Managerial Economics and Financial Analysis PDF

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LECTURE NOTES
ON
MANAGERIAL ECONOMICS AND

FINANCIAL ANALYSIS
III B.Tech I Semester (JNTUH-R13)
INFORMATION TECHNOLOGY
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UNIT-I
INTRODUCTION TO MANAGERIAL ECONOMICS
Imagine for a while that you have finished your studies and have joined as an engineer in a manufacturing
organization. What do you do there? You plan to produce maximum quantity of goods of a given quality at a
reasonable cost. On the other hand, if you are a sale manager, you have to sell a maximum amount of goods
with minimum advertisement costs. In other words, you want to minimize your costs and maximize your
returns and by doing so, you are practicing the principles of managerial economics.
Managers, in their day-to-day activities, are always confronted with several issues such as how much
quantity is to be supplied; at what price; should the product be made internally; or whether it should be
bought from outside; how much quantity is to be produced to make a given amount of profit and so on.
Managerial economics provides us a basic insight into seeking solutions for managerial problems.
Managerial economics, as the name itself implies, is an offshoot of two distinct disciplines: Economics and
Management. In other words, it is necessary to understand what these disciplines are, at least in brief, to
understand the nature and scope of managerial economics.
Introduction to Economics
Economics is a study of human activity both at individual and national level. The economists of early age
treated economics merely as the science of wealth. The reason for this is clear. Every one of us in involved in
efforts aimed at earning money and spending this money to satisfy our wants such as food, Clothing, shelter,
and others. Such activities of earning and spending money are called
“Economic activities”. It was only during the eighteenth century that Adam Smith, the Father of Economics,
defined economics as the study of nature and uses of national wealth’.
Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes “Economics is a study
of man’s actions in the ordinary business of life: it enquires how he gets his income and how he uses it”.
Thus, it is one side, a study of wealth; and on the other, and more important side; it is the study of man. As
Marshall observed, the chief aim of economics is to promote ‘human welfare’, but not wealth. The definition
given by AC Pigou endorses the opinion of Marshall. Pigou defines Economics as “the study of economic
welfare that can be brought directly and indirectly, into relationship with the measuring rod of money”.
Prof. Lionel Robbins defined Economics as “the science, which studies human behaviour as a relationship
between ends and scarce means which have alternative uses”. With this, the focus of economics shifted from
‘wealth’ to human behaviour’.
Lord Keynes defined economics as ‘the study of the administration of scarce means and the determinants of
employments and income”.
Microeconomics
The study of an individual consumer or a firm is called microeconomics (also called the Theory of Firm).
Micro means ‘one millionth’. Microeconomics deals with behavior and problems of single individual and of
micro organization. Managerial economics has its roots in microeconomics and it deals with the micro or
individual enterprises. It is concerned with the application of the concepts such as price theory, Law of
Demand and theories of market structure and so on.
Macroeconomics
The study of ‘aggregate’ or total level of economics activity in a country is called macroeconomics. It studies
the flow of economics resources or factors of production (such as land, labour, capital, organisation and
technology) from the resource owner to the business firms and then from the business firms to the
households. It deals with total aggregates, for instance, total national income total employment, output and
total investment. It studies the interrelations among various aggregates and examines their nature and
behaviour, their determination and causes of fluctuations in the. It deals with the price level in general,
instead of studying the prices of individual commodities. It is concerned with the level of employment in the
economy. It discusses aggregate consumption, aggregate investment, price level, and payment, theories of
employment, and so on.
Though macroeconomics provides the necessary framework in term of government policies etc., for the firm
to act upon dealing with analysis of business conditions, it has less direct relevance in the study of theory of
firm.
Management
Management is the science and art of getting things done through people in formally organized groups. It is
necessary that every organisation be well managed to enable it to achieve its desired goals. Management
includes a number of functions: Planning, organizing, staffing, directing, and controlling. The manager
while directing the efforts of his staff communicates to them the goals, objectives, policies, and procedures;
coordinates their efforts; motivates them to sustain their enthusiasm; and leads them to achieve the corporate
goals.
Welfare Economics
Welfare economics is that branch of economics, which primarily deals with taking of poverty, famine and
distribution of wealth in an economy. This is also called Development Economics. The central focus of
welfare economics is to assess how well things are going for the members of the society. If certain things
have gone terribly bad in some situation, it is necessary to explain why things have gone wrong. Prof.
Amartya Sen was awarded the Nobel Prize in Economics in 1998 in recognition of his contributions to
welfare economics. Prof. Sen gained recognition for his studies of the 1974 famine in Bangladesh. His work
has challenged the common view that food shortage is the major cause of famine.
In the words of Prof. Sen, famines can occur even when the food supply is high but people cannot buy the
food because they don’t have money. There has never been a famine in a democratic country because leaders
of those nations are spurred into action by politics and free media. In undemocratic countries, the rulers are
unaffected by famine and there is no one to hold them accountable, even when millions die.
Welfare economics takes care of what managerial economics tends to ignore. In other words, the growth for
an economic growth with societal upliftment is countered productive. In times of crisis, what comes to the
rescue of people is their won literacy, public health facilities, a system of food distribution, stable
democracy, social safety, (that is, systems or policies that take care of people when things go wrong for one
reason or other).
Managerial Economics
Introduction
Managerial Economics as a subject gained popularity in USA after the publication of the book “Managerial
Economics” by Joel Dean in 1951.
Managerial Economics refers to the firm’s decision making process. It could be also interpreted as
“Economics of Management” or “Economics of Management”. Managerial Economics is also called as
“Industrial Economics” or “Business Economics”.
As Joel Dean observes managerial economics shows how economic analysis can be used in formulating
polices.
Meaning & Definition:
In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the applications of economics
theory and methodology to business administration practice”.
Managerial Economics bridges the gap between traditional economics theory and real business practices in
two days. First it provides a number of tools and techniques to enable the manager to become more
competent to take decisions in real and practical situations. Secondly it serves as an integrating course to
show the interaction between various areas in which the firm operates.
C. I. Savage & T. R. Small therefore believes that managerial economics “is concerned with business
efficiency”.
M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the integration of economic
theory with business practice for the purpose of facilitating decision making and forward planning by
management”.
It is clear, therefore, that managerial economics deals with economic aspects of managerial decisions of with
those managerial decisions, which have an economics contest. Managerial economics may therefore, be
defined as a body of knowledge, techniques and practices which give substance to those economic concepts
which are useful in deciding the business strategy of a unit of management.
Managerial economics is designed to provide a rigorous treatment of those aspects of economic theory and
analysis that are most use for managerial decision analysis says J. L. Pappas and E. F. Brigham.
Managerial Economics, therefore, focuses on those tools and techniques, which are useful in decision-
making.
Nature of Managerial Economics
Managerial economics is, perhaps, the youngest of all the social sciences. Since it originates from
Economics, it has the basis features of economics, such as assuming that other things remaining the same (or
the Latin equivalent ceteris paribus). This assumption is made to simplify the complexity of the managerial
phenomenon under study in a dynamic business environment so many things are changing simultaneously.
This set a limitation that we cannot really hold other things remaining the same. In such a case, the
observations made out of such a study will have a limited purpose or value. Managerial economics also has
inherited this problem from economics.
Further, it is assumed that the firm or the buyer acts in a rational manner (which normally does not happen).
The buyer is carried away by the advertisements, brand loyalties, incentives and so on, and, therefore, the
innate behaviour of the consumer will be rational is not a realistic assumption. Unfortunately, there are no
other alternatives to understand the subject other than by making such assumptions. This is because the
behaviour of a firm or a consumer is a complex phenomenon.
The other features of managerial economics are explained as below:
(a) Close to microeconomics: Managerial economics is concerned with finding the solutions for
different managerial problems of a particular firm. Thus, it is more close to microeconomics.
(b) Operates against the backdrop of macroeconomics: The macroeconomics conditions of the
economy are also seen as limiting factors for the firm to operate. In other words, the managerial
economist has to be aware of the limits set by the macroeconomics conditions such as government
industrial policy, inflation and so on.
(c) Normative statements: A normative statement usually includes or implies the words ‘ought’ or
‘should’. They reflect people’s moral attitudes and are expressions of what a team of people ought
to do. For instance, it deals with statements such as ‘Government of India should open up the
economy. Such statement are based on value judgments and express views of what is ‘good’ or
‘bad’, ‘right’ or ‘ wrong’. One problem with normative statements is that they cannot to verify by
looking at the facts, because they mostly deal with the future. Disagreements about such statements
are usually settled by voting on them.
(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the objectives of the
firm, it suggests the course of action from the available alternatives for optimal solution. If does not
merely mention the concept, it also explains whether the concept can be applied in a given context
on not. For instance, the fact that variable costs are marginal costs can be used to judge the
feasibility of an export order.
(e) Applied in nature: ‘Models’ are built to reflect the real life complex business situations and these
models are of immense help to managers for decision-making. The different areas where models are
extensively used include inventory control, optimization, project management etc. In managerial
economics, we also employ case study methods to conceptualize the problem, identify that
alternative and determine the best course of action.
(f) Offers scope to evaluate each alternative: Managerial economics provides an opportunity to
evaluate each alternative in terms of its costs and revenue. The managerial economist can decide
which is the better alternative to maximize the profits for the firm.
(g) Interdisciplinary: The contents, tools and techniques of managerial economics are drawn from
different subjects such as economics, management, mathematics, statistics, accountancy,
psychology, organizational behavior, sociology and etc.
(h) Assumptions and limitations: Every concept and theory of managerial economics is based on
certain assumption and as such their validity is not universal. Where there is change in assumptions,
the theory may not hold good at all.
Scope of Managerial Economics:
The scope of managerial economics refers to its area of study. Managerial economics refers to its area of
study. Managerial economics, Provides management with a strategic planning tool that can be used to get a
clear perspective of the way the business world works and what can be done to maintain profitability in an
ever-changing environment. Managerial economics is primarily concerned with the application of economic
principles and theories to five types of resource decisions made by all types of business organizations.
a. The selection of product or service to be produced.

b. The choice of production methods and resource combinations.
c. The determination of the best price and quantity combination
d. Promotional strategy and activities.
e. The selection of the location from which to produce and sell goods or service to consumer.
The production department, marketing and sales department and the finance department usually handle these
five types of decisions.
The scope of managerial economics covers two areas of decision making
a. Operational or Internal issues

b. Environmental or External issues
a. Operational issues:
Operational issues refer to those, which wise within the business organization and they are under the control
of the management. Those are:
1. Theory of demand and Demand Forecasting
2. Pricing and Competitive strategy
3. Production cost analysis
4. Resource allocation
5. Profit analysis
6. Capital or Investment analysis
7. Strategic planning
1. Demand Analyses and Forecasting:
A firm can survive only if it is able to the demand for its product at the right time, within the right quantity.
Understanding the basic concepts of demand is essential for demand forecasting. Demand analysis should be
a basic activity of the firm because many of the other activities of the firms depend upon the outcome of the
demand fore cost. Demand analysis provides:
1. The basis for analyzing market influences on the firms; products and thus helps in the adaptation to
those influences.
2. Demand analysis also highlights for factors, which influence the demand for a product. This helps to
manipulate demand. Thus demand analysis studies not only the price elasticity but also income
elasticity, cross elasticity as well as the influence of advertising expenditure with the advent of
computers, demand forecasting has become an increasingly important function of managerial
economics.
2. Pricing and competitive strategy:
Pricing decisions have been always within the preview of managerial economics. Pricing policies are merely
a subset of broader class of managerial economic problems. Price theory helps to explain how prices are
determined under different types of market conditions. Competitions analysis includes the anticipation of the
response of competitions the firm’s pricing, advertising and marketing strategies. Product line pricing and
price forecasting occupy an important place here.
3. Production and cost analysis:
Production analysis is in physical terms. While the cost analysis is in monetary terms cost concepts and
classifications, cost-out-put relationships, economies and diseconomies of scale and production functions are
some of the points constituting cost and production analysis.
4. Resource Allocation:
Managerial Economics is the traditional economic theory that is concerned with the problem of optimum
allocation of scarce resources. Marginal analysis is applied to the problem of determining the level of output,
which maximizes profit. In this respect linear programming techniques has been used to solve optimization
problems. In fact lines programming is one of the most practical and powerful managerial decision making
tools currently available.
5. Profit analysis:
Profit making is the major goal of firms. There are several constraints here an account of competition from
other products, changing input prices and changing business environment hence in spite of careful planning,
there is always certain risk involved. Managerial economics deals with techniques of averting of minimizing
risks. Profit theory guides in the measurement and management of profit, in calculating the pure return on
capital, besides future profit planning.
6. Capital or investment analyses:
Capital is the foundation of business. Lack of capital may result in small size of operations. Availability of
capital from various sources like equity capital, institutional finance etc. may help to undertake large-scale
operations. Hence efficient allocation and management of capital is one of the most important tasks of the
managers. The major issues related to capital analysis are:
1. The choice of investment project

2. Evaluation of the efficiency of capital
3. Most efficient allocation of capital
Knowledge of capital theory can help very much in taking investment decisions. This involves, capital
budgeting, feasibility studies, analysis of cost of capital etc.
7. Strategic planning:
Strategic planning provides management with a framework on which long-term decisions can be made which
has an impact on the behavior of the firm. The firm sets certain long-term goals and objectives and selects
the strategies to achieve the same. Strategic planning is now a new addition to the scope of managerial
economics with the emergence of multinational corporations. The perspective of strategic planning is global.
It is in contrast to project planning which focuses on a specific project or activity. In fact the integration of
managerial economics and strategic planning has given rise to be new area of study called corporate
economics.
B. Environmental or External Issues:
An environmental issue in managerial economics refers to the general business environment in which the
firm operates. They refer to general economic, social and political atmosphere within which the firm
operates. A study of economic environment should include:
a. The type of economic system in the country.

b. The general trends in production, employment, income, prices, saving and investment.
c. Trends in the working of financial institutions like banks, financial corporations, insurance
companies
d. Magnitude and trends in foreign trade;
e. Trends in labour and capital markets;
f. Government’s economic policies viz. industrial policy monetary policy, fiscal policy, price policy
etc.
The social environment refers to social structure as well as social organization like trade unions, consumer’s
co-operative etc. The Political environment refers to the nature of state activity, chiefly states’ attitude
towards private business, political stability etc.
The environmental issues highlight the social objective of a firm i.e.; the firm owes a responsibility to the
society. Private gains of the firm alone cannot be the goal.
The environmental or external issues relate managerial economics to macro economic theory while
operational issues relate the scope to micro economic theory. The scope of managerial economics is ever
widening with the dynamic role of big firms in a society.
Managerial economics relationship with other disciplines:
Many new subjects have evolved in recent years due to the interaction among basic disciplines. While there
are many such new subjects in natural and social sciences, managerial economics can be taken as the best
example of such a phenomenon among social sciences. Hence it is necessary to trace its roots and relation
ship with other disciplines.
1. Relationship with economics:
The relationship between managerial economics and economics theory may be viewed form the point of
view of the two approaches to the subject Viz. Micro Economics and Marco Economics. Microeconomics is
the study of the economic behavior of individuals, firms and other such micro organizations. Managerial
economics is rooted in Micro Economic theory. Managerial Economics makes use to several Micro
Economic concepts such as marginal cost, marginal revenue, elasticity of demand as well as price theory and
theories of market structure to name only a few. Macro theory on the other hand is the study of the economy
as a whole. It deals with the analysis of national income, the level of employment, general price level,
consumption and investment in the economy and even matters related to international trade, Money, public
finance, etc.
The relationship between managerial economics and economics theory is like that of engineering science to
physics or of medicine to biology. Managerial economics has an applied bias and its wider scope lies in
applying economic theory to solve real life problems of enterprises. Both managerial economics and
economics deal with problems of scarcity and resource allocation.
2. Management theory and accounting:
Managerial economics has been influenced by the developments in management theory and accounting
techniques. Accounting refers to the recording of pecuniary transactions of the firm in certain books. A
proper knowledge of accounting techniques is very essential for the success of the firm because profit
maximization is the major objective of the firm.
Managerial Economics requires a proper knowledge of cost and revenue information and their classification.
A student of managerial economics should be familiar with the generation, interpretation and use of
accounting data. The focus of accounting within the firm is fast changing from the concepts of store keeping
to that if managerial decision making, this has resulted in a new specialized area of study called “Managerial
Accounting”.
3. Managerial Economics and mathematics:
The use of mathematics is significant for managerial economics in view of its profit maximization goal long
with optional use of resources. The major problem of the firm is how to minimize cost, hoe to maximize
profit or how to optimize sales. Mathematical concepts and techniques are widely used in economic logic to
solve these problems. Also mathematical methods help to estimate and predict the economic factors for
decision making and forward planning.
Mathematical symbols are more convenient to handle and understand various concepts like incremental cost,
elasticity of demand etc., Geometry, Algebra and calculus are the major branches of mathematics which are
of use in managerial economics. The main concepts of mathematics like logarithms, and exponentials,
vectors and determinants, input-output models etc., are widely used. Besides these usual tools, more
advanced techniques designed in the recent years viz. linear programming, inventory models and game
theory fine wide application in managerial economics.
4. Managerial Economics and Statistics:
Managerial Economics needs the tools of statistics in more than one way. A successful businessman must
correctly estimate the demand for his product. He should be able to analyses the impact of variations in
tastes. Fashion and changes in income on demand only then he can adjust his output. Statistical methods
provide and sure base for decision-making. Thus statistical tools are used in collecting data and analyzing
them to help in the decision making process.
Statistical tools like the theory of probability and forecasting techniques help the firm to predict the future
course of events. Managerial Economics also make use of correlation and multiple regressions in related
variables like price and demand to estimate the extent of dependence of one variable on the other. The theory
of probability is very useful in problems involving uncertainty.
5. Managerial Economics and Operations Research:
Taking effectives decisions is the major concern of both managerial economics and operations research. The
development of techniques and concepts such as linear programming, inventory models and game theory is
due to the development of this new subject of operations research in the postwar years. Operations research
is concerned with the complex problems arising out of the management of men, machines, materials and
money.
Operation research provides a scientific model of the system and it helps managerial economists in the field
of product development, material management, and inventory control, quality control, marketing and
demand analysis. The varied tools of operations Research are helpful to managerial economists in decision-
making.
6. Managerial Economics and the theory of Decision- making:
The Theory of decision-making is a new field of knowledge grown in the second half of this century. Most
of the economic theories explain a single goal for the consumer i.e., Profit maximization for the firm. But the
theory of decision-making is developed to explain multiplicity of goals and lot of uncertainty.
As such this new branch of knowledge is useful to business firms, which have to take quick decision in the
case of multiple goals. Viewed this way the theory of decision making is more practical and application
oriented than the economic theories.
7. Managerial Economics and Computer Science:
Computers have changes the way of the world functions and economic or business activity is no exception.
Computers are used in data and accounts maintenance, inventory and stock controls and supply and demand
predictions. What used to take days and months is done in a few minutes or hours by the computers. In fact
computerization of business activities on a large scale has reduced the workload of managerial personnel. In
most countries a basic knowledge of computer science, is a compulsory programme for managerial trainees.
To conclude, managerial economics, which is an offshoot traditional economics, has gained strength to be a
separate branch of knowledge. It strength lies in its ability to integrate ideas from various specialized
subjects to gain a proper perspective for decision-making.
A successful managerial economist must be a mathematician, a statistician and an economist. He must be

also able to combine philosophic methods with historical methods to get the right perspective only then; he
will be good at predictions. In short managerial practices with the help of other allied sciences.
THE ROLE OF MANAGERIAL ECONOMIST
Making decisions and processing information are the two primary tasks of the managers. Managerial
economists have gained importance in recent years with the emergence of an organizational culture in
production and sales activities.
A management economist with sound knowledge of theory and analytical tools for information system
occupies a prestigious place among the personnel. A managerial economist is nearer to the policy-making.
Equipped with specialized skills and modern techniques he analyses the internal and external operations of
the firm. He evaluates and helps in decision making regarding sales, Pricing financial issues, labour relations
and profitability. He helps in decision-making keeping in view the different goals of the firm.
His role in decision-making applies to routine affairs such as price fixation, improvement in quality,
Location of plant, expansion or contraction of output etc. The role of managerial economist in internal
management covers wide areas of production, sales and inventory schedules of the firm.
The most important role of the managerial economist relates to demand forecasting because an analysis of
general business conditions is most vital for the success of the firm. He prepares a short-term forecast of
general business activity and relates general economic forecasts to specific market trends. Most firms require
two forecasts one covering the short term (for nest three months to one year) and the other covering the long
term, which represents any period exceeding one-year. He has to be ever alert to gauge the changes in tastes
and preferences of the consumers. He should evaluate the market potential. The need to know forecasting
techniques on the part of the managerial economics means, he should be adept at market research. The
purpose of market research is to provide a firm with information about current market position as well as
present and possible future trends in the industry. A managerial economist who is well equipped with this
knowledge can help the firm to plan product improvement, new product policy, pricing, and sales promotion
strategy.
The fourth function of the managerial economist is to undertake an economic analysis of the industry. This is
concerned with project evaluation and feasibility study at the firm level i.e., he should be able to judge on the
basis of cost benefit analysis, whether it is advisable and profitable to go ahead with the project. The
managerial economist should be adept at investment appraisal methods. At the external level, economic
analysis involves the knowledge of competition involved, possibility of internal and foreign sales, the
general business climate etc.
Another function is security management analysis. This is very important in the case of defense-oriented
industries, power projects, and nuclear plants where security is very essential. Security management means,
also that the production and trade secrets concerning technology, quality and other such related facts should
not be leaked out to others. This security is more necessary in strategic and defense-oriented projects of
national importance; a managerial economist should be able to manage these issues of security management
analysis.
The sixth function is an advisory function. Here his advice is required on all matters of production and trade.
In the hierarchy of management, a managerial economist ranks next to the top executives or the policy maker
who may be doyens of several projects. It is the managerial economist of each firm who has to advise them
on all matters of trade since they are in the know of actual functioning of the unit in all aspects, both
technical and financial.
Another function of importance for the managerial economist is a concerned with pricing and related
problems. The success of the firm depends upon a proper pricing strategy. The pricing decision is one of the
most difficult decisions to be made in business because the information required is never fully available.
Pricing of established products is different from new products. He may have to operate in an atmosphere
constrained by government regulation. He may have to anticipate the reactions of competitors in pricing. The
managerial economist has to be very alert and dynamic to take correct pricing decision in changing
environment.
Finally the specific function of a managerial economist includes an analysis of environment issues. Modern
theory of managerial economics recognizes the social responsibility of the firm. It refers to the impact of a
firm on environmental factors. It should not have adverse impact on pollution and if possible try to
contribute to environmental preservation and protection in a positive way.
The role of management economist lies not in taking decision but in analyzing, concluding and
recommending to the policy maker. He should have the freedom to operate and analyze and must possess full
knowledge of facts. He has to collect and provide the quantitative data from within the firm. He has to get
information on external business environment such as general market conditions, trade cycles, and behavior
pattern of the consumers. The managerial economist helps to co-ordinate policies relating to production,
investment, inventories and price.
He should have equanimity to meet crisis. He should act only after analysis and discussion with relevant
departments. He should have diplomacy to act in advisory capacity to the top executive as well as getting co-
operation from different departments for his economic analysis. He should do well to have intuitive ability to
know what is good or bad for the firm.
He should have sound theoretical knowledge to take up the challenges he has to face in actual day to day
affairs. “BANMOL” referring to the role of managerial economist points out. “A managerial economist can
become a for more helpful member of a management group by virtue of studies of economic analysis,
primarily because there he learns to become an effective model builder and because there he acquires a very
rich body of tools and techniques which can help to deal with the problems of the firm in a far more rigorous,
a far more probing and a far deeper manner”.
QUESTIONS
1. What is managerial economics? Explain its focus are as

2. Point out the importance of managerial economics in decision making
3. What are the contributions and limitations of economic analysis in business decision making
4. Managerial Economics is the discipline which deals with the applications of economic theory to
business management discuss.
5. Explain the fundamental concepts of managerial economics
6. Discuss the nature & Scope of Managerial economics
7. Managerial Economics is the study of allocation of resources available to a firm or other unit of
management among the activities of that unit explains.
8. Explain the nature of problems studies in managerial economics. What is the importance of the study
of such problems in business management?
9. Explain the role and responsibilities of a managerial economics?
10. “Managerial Economics is an integration of economic theory and with business practice for the
purpose of facilitating decision making and forward planning” explain.
QUIZ
1. Managerial Economics as a subject gained popularity first in______. ( )

(a) India (b) Germany (c) U.S.A (d) England
2. When the subject Managerial Economics gained popularity? ( )

(a) 1950 (b) 1949 (c) 1951 (d) 1952
3. Which subject studies the behavior of the firm in theory and practice? ( )
(a) Micro Economics (b) Macro Economics
(c) Managerial Economics (d) Welfare Economics
4. Which subject bridges gap between Economic Theory and Management

Practice? ( )
(a) Welfare Economics (b) Micro Economics
(c) Managerial Economics (d) Macro Economics
5. Application of Economics for managerial decision-making is called____. ( )

(a) Macro Economics (b) Welfare Economics
(c) Managerial Economics (d) Micro Economics
6. Which areas covered by the subject “Managerial Economics”. ( )

(a) Operational issues (b) Environmental issues
(c) Operational & Environmental issues (d) None
7. The relationship between Managerial Economics and Economic Theory is

like that of Engineering Science to Physics (or) Medicine to ___________. ( )
(a) Mathematics (b) Economics
(c) Biology (d) Accountancy
8. Making decisions and processing information are the two Primary tasks of
the Managers . It was explained by the subject _____________________. ( )
(a) Physics (b) Engineering Science
(c) Managerial Economics (d) Chemistry
9. Managerial Economics is close to_________Economics ( )

(a) National (b) Business (c) Micro (d) Industrial
10. The theory of firm also called as_____________. ( )

(a) Welfare Economics (b) Industrial Economics
(c) Micro Economics (d) None
11. “Any activity aimed at earning or spending money is called ____activity”. ( )

(a) Service activity (b) Accounting activity
(c) Economic activity (d) None
Note: Answer is “C” for all the above questions.
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DEMAND ANALYSIS
Introduction & Meaning:
Demand in common parlance means the desire for an object. But in economics demand is something more
than this. According to Stonier and Hague, “Demand in economics means demand backed up by enough
money to pay for the goods demanded”. This means that the demand becomes effective only it if is backed
by the purchasing power in addition to this there must be willingness to buy a commodity.
Thus demand in economics means the desire backed by the willingness to buy a commodity and the
purchasing power to pay. In the words of “Benham” “The demand for anything at a given price is the amount
of it which will be bought per unit of time at that Price”. (Thus demand is always at a price for a definite
quantity at a specified time.) Thus demand has three essentials – price, quantity demanded and time. Without
these, demand has to significance in economics.
LAW of Demand:
Law of demand shows the relation between price and quantity demanded of a commodity in the market. In
the words of Marshall, “the amount demand increases with a fall in price and diminishes with a rise in price”.
A rise in the price of a commodity is followed by a reduction in demand and a fall in price is followed by an
increase in demand, if a condition of demand remains constant.
The law of demand may be explained with the help of the following demand schedule.
Demand Schedule.
Price of Appel (In. Rs.) Quantity Demanded

10 1
8 2
6 3
4 4
2 5
When the price falls from Rs. 10 to 8

quantity demand increases from 1 to 2. In
the same way as price falls, quantity demand
increases on the basis of the demand schedule
we can draw the demand curve.
Price
The demand curve DD shows the inverse relation between price and quantity demand of apple. It is
downward sloping.
Assumptions:
Law is demand is based on certain assumptions:
1. This is no change in consumers taste and preferences.

2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity
5. The commodity should not confer at any distinction
6. The demand for the commodity should be continuous
7. People should not expect any change in the price of the commodity
Exceptional demand curve:
Some times the demand curve slopes upwards from left to right. In this case the demand curve has a positive
slope.
Price
When price increases from OP to Op1 quantity demanded also increases from to OQ1 and vice versa. The
reasons for exceptional demand curve are as follows.
1. Giffen paradox:
The Giffen good or inferior good is an exception to the law of demand. When the price of an inferior good
falls, the poor will buy less and vice versa. For example, when the price of maize falls, the poor are willing to
spend more on superior goods than on maize if the price of maize increases, he has to increase the quantity of
money spent on it. Otherwise he will have to face starvation. Thus a fall in price is followed by reduction in
quantity demanded and vice versa. “Giffen” first explained this and therefore it is called as Giffen’s paradox.
2. Veblen or Demonstration effect:
‘Veblan’ has explained the exceptional demand curve through his doctrine of conspicuous consumption.
Rich people buy certain good because it gives social distinction or prestige for example diamonds are bought
by the richer class for the prestige it possess. It the price of diamonds falls poor also will buy is hence they
will not give prestige. Therefore, rich people may stop buying this commodity.
3. Ignorance:
Sometimes, the quality of the commodity is Judge by its price. Consumers think that the product is superior
if the price is high. As such they buy more at a higher price.
4. Speculative effect:
If the price of the commodity is increasing the consumers will buy more of it because of the fear that it
increase still further, Thus, an increase in price may not be accomplished by a decrease in demand.
5. Fear of shortage:
During the times of emergency of war People may expect shortage of a commodity. At that time, they may
buy more at a higher price to keep stocks for the future.
5. Necessaries:
In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.
Factors Affecting Demand:
There are factors on which the demand for a commodity depends. These factors are economic, social as well
as political factors. The effect of all the factors on the amount demanded for the commodity is called
Demand Function.
These factors are as follows:
1. Price of the Commodity:
The most important factor-affecting amount demanded is the price of the commodity. The amount of a
commodity demanded at a particular price is more properly called price demand. The relation between price
and demand is called the Law of Demand. It is not only the existing price but also the expected changes in
price, which affect demand.
2. Income of the Consumer:
The second most important factor influencing demand is consumer income. In fact, we can establish a
relation between the consumer income and the demand at different levels of income, price and other things
remaining the same. The demand for a normal commodity goes up when income rises and falls down when
income falls. But in case of Giffen goods the relationship is the opposite.
3. Prices of related goods:
The demand for a commodity is also affected by the changes in prices of the related goods also. Related
goods can be of two types:
(i). Substitutes which can replace each other in use; for example, tea and coffee are
substitutes. The change in price of a substitute has effect on a commodity’s demand
in the same direction in which price changes. The rise in price of coffee shall raise
the demand for tea;
(ii). Complementary foods are those which are jointly demanded, such as pen and ink. In
such cases complementary goods have opposite relationship between price of one
commodity and the amount demanded for the other. If the price of pens goes up,
their demand is less as a result of which the demand for ink is also less. The price
and demand go in opposite direction. The effect of changes in price of a commodity on
amounts demanded of related commodities is called Cross Demand.
4. Tastes of the Consumers:
The amount demanded also depends on consumer’s taste. Tastes include fashion, habit, customs, etc. A
consumer’s taste is also affected by advertisement. If the taste for a commodity goes up, its amount
demanded is more even at the same price. This is called increase in demand. The opposite is called decrease
in demand.
5. Wealth:
The amount demanded of commodity is also affected by the amount of wealth as well as its distribution. The
wealthier are the people; higher is the demand for normal commodities. If wealth is more equally distributed,
the demand for necessaries and comforts is more. On the other hand, if some people are rich, while the
majorities are poor, the demand for luxuries is generally higher.
6. Population:
Increase in population increases demand for necessaries of life. The composition of population also affects
demand. Composition of population means the proportion of young and old and children as well as the ratio
of men to women. A change in composition of population has an effect on the nature of demand for different
commodities.
7. Government Policy:
Government policy affects the demands for commodities through taxation. Taxing a commodity increases its
price and the demand goes down. Similarly, financial help from the government increases the demand for a
commodity while lowering its price.
8. Expectations regarding the future:
If consumers expect changes in price of commodity in future, they will change the demand at present even
when the present price remains the same. Similarly, if consumers expect their incomes to rise in the near
future they may increase the demand for a commodity just now.
9. Climate and weather:
The climate of an area and the weather prevailing there has a decisive effect on consumer’s demand. In cold
areas woolen cloth is demanded. During hot summer days, ice is very much in demand. On a rainy day, ice
cream is not so much demanded.
10. State of business:
The level of demand for different commodities also depends upon the business conditions in the country. If
the country is passing through boom conditions, there will be a marked increase in demand. On the other
hand, the level of demand goes down during depression.
ELASTICITY OF DEMAND
Elasticity of demand explains the relationship between a change in price and consequent change in amount
demanded. “Marshall” introduced the concept of elasticity of demand. Elasticity of demand shows the extent
of change in quantity demanded to a change in price.
In the words of “Marshall”, “The elasticity of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in the price and diminishes much or little for a given rise in
Price”
Elastic demand: A small change in price may lead to a great change in quantity demanded. In this case,
demand is elastic.
In-elastic demand: If a big change in price is followed by a small change in demanded then the demand in
“inelastic”.
Types of Elasticity of Demand:
There are three types of elasticity of demand:
1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
1. Price elasticity of demand:
Marshall was the first economist to define price elasticity of demand. Price elasticity of demand measures
changes in quantity demand to a change in Price. It is the ratio of percentage change in quantity demanded to
a percentage change in price.
Proportionate change in the quantity demand of commodity

Price elasticity = ------------------------------------------------------------------
Proportionate change in the price of commodity
There are five cases of price elasticity of demand
A. Perfectly elastic demand:
When small change in price leads to an infinitely large change is quantity demand, it is called perfectly or
infinitely elastic demand. In this case E=∞
The demand curve DD1 is horizontal straight line. It shows the at “OP” price any amount is demand and if
price increases, the consumer will not purchase the commodity.
B. Perfectly Inelastic Demand
In this case, even a large change in price fails to bring about a change in quantity demanded.
When price increases from ‘OP’ to ‘OP’, the quantity demanded remains the same. In other words the
response of demand to a change in Price is nil. In this case ‘E’=0.
C. Relatively elastic demand:
Demand changes more than proportionately to a change in price. i.e. a small change in price loads to a very
big change in the quantity demanded. In this case
E > 1. This demand curve will be flatter.
When price falls from ‘OP’ to ‘OP’, amount demanded in crease from “OQ’ to “OQ1’ which is larger than
the change in price.
D. Relatively in-elastic demand.
Quantity demanded changes less than proportional to a change in price. A large change in price leads to
small change in amount demanded. Here E < 1. Demanded carve will be steeper.
When price falls from “OP’ to ‘OP1 amount demanded increases from OQ to OQ1, which is smaller than the
change in price.
E. Unit elasticity of demand:
The change in demand is exactly equal to the change in price. When both are equal E=1 and elasticity if said
to be unitary.
When price falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to ‘OP1’, quantity demanded
increases from ‘OQ’ to ‘OQ1’. Thus a change in price has resulted in an equal change in quantity demanded
so price elasticity of demand is equal to unity.
2. Income elasticity of demand:
Income elasticity of demand shows the change in quantity demanded as a result of a change in income.
Income elasticity of demand may be slated in the form of a formula.
Proportionate change in the quantity demand of commodity

Income Elasticity = ------------------------------------------------------------------
Proportionate change in the income of the people
Income elasticity of demand can be classified in to five types.
A. Zero income elasticity:
Quantity demanded remains the same, even though money income increases. Symbolically, it can be
expressed as Ey=0. It can be depicted in the following way:
As income increases from OY to

OY1, quantity demanded never changes.
B. Negative Income elasticity:
When income increases, quantity demanded falls. In this case, income elasticity of demand is negative. i.e.,
Ey < 0.
When income increases from OY to OY1, demand falls from OQ to OQ1.
c. Unit income elasticity:
When an increase in income brings about a proportionate increase in quantity demanded, and then income
elasticity of demand is equal to one. Ey = 1
When income increases from OY to OY1, Quantity demanded also increases from OQ to OQ1.
d. Income elasticity greater than unity:
In this case, an increase in come brings about a more than proportionate increase in quantity demanded.
Symbolically it can be written as Ey > 1.
It shows high-income elasticity of demand. When income increases from OY

to OY1, Quantity demanded increases from OQ to OQ1.
E. Income elasticity leas than unity:
When income increases quantity demanded also increases but less than proportionately. In this case E < 1.
An increase in income from OY to OY, brings what an increase in quantity demanded from OQ to OQ1, But
the increase in quantity demanded is smaller than the increase in income. Hence, income elasticity of
demand is less than one.
3. Cross elasticity of Demand:
A change in the price of one commodity leads to a change in the quantity demanded of another commodity.
This is called a cross elasticity of demand. The formula for cross elasticity of demand is:
Proportionate change in the quantity demand of commodity “X”

Cross elasticity = -----------------------------------------------------------------------
Proportionate change in the price of commodity “Y”
a. In case of substitutes, cross elasticity of demand is positive. Eg: Coffee and Tea
When the price of coffee increases, Quantity demanded of

tea increases. Both are substitutes.
Price of Coffee
b. Incase of compliments, cross elasticity is negative. If increase in the price of one commodity leads to a
decrease in the quantity demanded of another and vice versa.
When price of car goes up from OP to OP!, the quantity demanded of petrol decreases from OQ to OQ!. The
cross-demanded curve has negative slope.
c. In case of unrelated commodities, cross elasticity of demanded is zero. A change in the price of one
commodity will not affect the quantity demanded of another.
Quantity demanded of commodity “b” remains unchanged due to a change in the price of ‘A’, as both are
unrelated goods.
Factors influencing the elasticity of demand
Elasticity of demand depends on many factors.
1. Nature of commodity:
Elasticity or in-elasticity of demand depends on the nature of the commodity i.e. whether a commodity is a
necessity, comfort or luxury, normally; the demand for Necessaries like salt, rice etc is inelastic. On the other
band, the demand for comforts and luxuries is elastic.
2. Availability of substitutes:
Elasticity of demand depends on availability or non-availability of substitutes. In case of commodities, which

have substitutes, demand is elastic, but in case of commodities, which have no substitutes, demand is in elastic.
3. Variety of uses:
If a commodity can be used for several purposes, than it will have elastic demand. i.e. electricity. On the other
hand, demanded is inelastic for commodities, which can be put to only one use.
4. Postponement of demand:
If the consumption of a commodity can be postponed, than it will have elastic demand. On the contrary, if the
demand for a commodity cannot be postpones, than demand is in elastic. The demand for rice or medicine cannot
be postponed, while the demand for Cycle or umbrella can be postponed.
5. Amount of money spent:
Elasticity of demand depends on the amount of money spent on the commodity. If the consumer spends a smaller
for example a consumer spends a little amount on salt and matchboxes. Even when price of salt or matchbox goes
up, demanded will not fall. Therefore, demand is in case of clothing a consumer spends a large proportion of his
income and an increase in price will reduce his demand for clothing. So the demand is elastic.
6. Time:
Elasticity of demand varies with time. Generally, demand is inelastic during short period and elastic during the
long period. Demand is inelastic during short period because the consumers do not have enough time to know
about the change is price. Even if they are aware of the price change, they may not immediately switch over to a
new commodity, as they are accustomed to the old commodity.
7. Range of Prices:
Range of prices exerts an important influence on elasticity of demand. At a very high price, demand is inelastic
because a slight fall in price will not induce the people buy more. Similarly at a low price also demand is inelastic.
This is because at a low price all those who want to buy the commodity would have bought it and a further fall in
price will not increase the demand. Therefore, elasticity is low at very him and very low prices.
Importance of Elasticity of Demand:
The concept of elasticity of demand is of much practical importance.
1. Price fixation:
Each seller under monopoly and imperfect competition has to take into account elasticity of demand while fixing
the price for his product. If the demand for the product is inelastic, he can fix a higher price.
2. Production:
Producers generally decide their production level on the basis of demand for the product. Hence elasticity of
demand helps the producers to take correct decision regarding the level of cut put to be produced.
3. Distribution:
Elasticity of demand also helps in the determination of rewards for factors of production. For example, if the
demand for labour is inelastic, trade unions will be successful in raising wages. It is applicable to other factors of
production.
4. International Trade:
Elasticity of demand helps in finding out the terms of trade between two countries. Terms of trade refers to the
rate at which domestic commodity is exchanged for foreign commodities. Terms of trade depends upon the
elasticity of demand of the two countries for each other goods.
5. Public Finance:
Elasticity of demand helps the government in formulating tax policies. For example, for imposing tax on a
commodity, the Finance Minister has to take into account the elasticity of demand.
6. Nationalization:
The concept of elasticity of demand enables the government to decide about nationalization of industries.
Demand Forecasting
Introduction:
The information about the future is essential for both new firms and those planning to expand the scale of their
production. Demand forecasting refers to an estimate of future demand for the product.
It is an ‘objective assessment of the future course of demand”. In recent times, forecasting plays an important role
in business decision-making. Demand forecasting has an important influence on production planning. It is
essential for a firm to produce the required quantities at the right time.
It is essential to distinguish between forecasts of demand and forecasts of sales. Sales forecast is important for
estimating revenue cash requirements and expenses. Demand forecasts relate to production, inventory control,
timing, reliability of forecast etc. However, there is not much difference between these two terms.
Types of demand Forecasting:
Based on the time span and planning requirements of business firms, demand forecasting can be classified in to 1.
Short-term demand forecasting and
2. Long – term demand forecasting.
1. Short-term demand forecasting:
Short-term demand forecasting is limited to short periods, usually for one year. It relates to policies regarding
sales, purchase, price and finances. It refers to existing production capacity of the firm. Short-term forecasting is
essential for formulating is essential for formulating a suitable price policy. If the business people expect of rise in
the prices of raw materials of shortages, they may buy early. This price forecasting helps in sale policy
formulation. Production may be undertaken based on expected sales and not on actual sales. Further, demand
forecasting assists in financial forecasting also. Prior information about production and sales is essential to
provide additional funds on reasonable terms.
2. Long – term forecasting:
In long-term forecasting, the businessmen should now about the long-term demand for the product. Planning of a
new plant or expansion of an existing unit depends on long-term demand. Similarly a multi product firm must take
into account the demand for different items. When forecast are mode covering long periods, the probability of
error is high. It is vary difficult to forecast the production, the trend of prices and the nature of competition. Hence
quality and competent forecasts are essential.
Prof. C. I. Savage and T.R. Small classify demand forecasting into time types. They are 1. Economic forecasting,
2. Industry forecasting, 3. Firm level forecasting. Economics forecasting is concerned with the economics, while
industrial level forecasting is used for inter-industry comparisons and is being supplied by trade association or
chamber of commerce. Firm level forecasting relates to individual firm.
Methods of forecasting:
Several methods are employed for forecasting demand. All these methods can be grouped under survey method
and statistical method. Survey methods and statistical methods are further subdivided in to different categories.
1. Survey Method:
Under this method, information about the desires of the consumer and opinion of exports are collected by
interviewing them. Survey method can be divided into four type’s viz., Option survey method; expert opinion;
Delphi method and consumers interview methods.
a. Opinion survey method:
This method is also known as sales-force composite method (or) collective opinion method. Under this method,
the company asks its salesman to submit estimate of future sales in their respective territories. Since the forecasts
of the salesmen are biased due to their optimistic or pessimistic attitude ignorance about economic developments
etc. these estimates are consolidated, reviewed and adjusted by the top executives. In case of wide differences, an
average is struck to make the forecasts realistic.
This method is more useful and appropriate because the salesmen are more knowledge. They can be important
source of information. They are cooperative. The implementation within unbiased or their basic can be corrected.
B. Expert opinion method:
Apart from salesmen and consumers, distributors or outside experts may also e used for forecasting. In the United
States of America, the automobile companies get sales estimates directly from their dealers. Firms in advanced
countries make use of outside experts for estimating future demand. Various public and private agencies all
periodic forecasts of short or long term business conditions.
C. Delphi Method:
A variant of the survey method is Delphi method. It is a sophisticated method to arrive at a consensus. Under this
method, a panel is selected to give suggestions to solve the problems in hand. Both internal and external experts
can be the members of the panel. Panel members one kept apart from each other and express their views in an
anonymous manner. There is also a coordinator who acts as an intermediary among the panelists. He prepares the
questionnaire and sends it to the panelist. At the end of each round, he prepares a summary report. On the basis of
the summary report the panel members have to give suggestions. This method has been used in the area of
technological forecasting. It has proved more popular in forecasting. It has provided more popular in forecasting
non-economic rather than economic variables.
D. Consumers interview method:
In this method the consumers are contacted personally to know about their plans and preference regarding the
consumption of the product. A list of all potential buyers would be drawn and each buyer will be approached and
asked how much he plans to buy the listed product in future. He would be asked the proportion in which he
intends to buy. This method seems to be the most ideal method for forecasting demand.
2. Statistical Methods:
Statistical method is used for long run forecasting. In this method, statistical and mathematical techniques are used
to forecast demand. This method relies on post data.
a. Time series analysis or trend projection methods:
A well-established firm would have accumulated data. These data are analyzed to determine the nature of existing
trend. Then, this trend is projected in to the future and the results are used as the basis for forecast. This is called
as time series analysis. This data can be presented either in a tabular form or a graph. In the time series post data
of sales are used to forecast future.
b. Barometric Technique:
Simple trend projections are not capable of forecasting turning paints. Under Barometric method, present events
are used to predict the directions of change in future. This is done with the help of economics and statistical
indicators. Those are (1) Construction Contracts awarded for building materials (2) Personal income (3)
Agricultural Income. (4) Employment (5) Gross national income (6) Industrial Production (7) Bank Deposits etc.
c. Regression and correlation method:
Regression and correlation are used for forecasting demand. Based on post data the future data trend is forecasted.
If the functional relationship is analyzed with the independent variable it is simple correction. When there are
several independent variables it is multiple correlation. In correlation we analyze the nature of relation between
the variables while in regression; the extent of relation between the variables is analyzed. The results are
expressed in mathematical form. Therefore, it is called as econometric model building. The main advantage of this
method is that it provides the values of the independent variables from within the model itself.
UNIT - II
PRODUCTION FUNCTION
Introduction: The production function expresses a functional relationship between physical inputs and physical
outputs of a firm at any particular time period. The output is thus a function of inputs. Mathematically production
function can be written as
Q= f (A, B, C, D)
Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land, labour, capital
and organization. Here output is the function of inputs. Hence output becomes the dependent variable and inputs
are the independent variables.
The above function does not state by how much the output of “Q” changes as a consequence of change of variable
inputs. In order to express the quantitative relationship between inputs and output, Production function has been
expressed in a precise mathematical equation i.e.
Y= a+b(x)
Which shows that there is a constant relationship between applications of input (the only factor input ‘X’ in this
case) and the amount of output (y) produced.
Importance:
1. When inputs are specified in physical units, production function helps to estimate the level of production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without altering the total
output.
4. When price is taken into consideration, the production function helps to select the least combination of
inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable proportions’ and ‘law of returns
to scale’. Law of variable propositions explains the pattern of output in the short-run as the units of
variable inputs are increased to increase the output. On the other hand law of returns to scale explains the
pattern of output in the long run as all the units of inputs are increased.
6. The production function explains the maximum quantity of output, which can be produced, from any
chosen quantities of various inputs or the minimum quantities of various inputs that are required to
produce a given quantity of output.
Production function can be fitted the particular firm or industry or for the economy as whole. Production function
will change with an improvement in technology.
Assumptions:
Production function has the following assumptions.
1. The production function is related to a particular period of time.

2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.
Cobb-Douglas production function:
Production function of the linear homogenous type is invested by Junt wicksell and first tested by C. W. Cobb and
P. H. Dougles in 1928. This famous statistical production function is known as Cobb-Douglas production
function. Originally the function is applied on the empirical study of the American manufacturing industry. Cabb
– Douglas production function takes the following mathematical form.
Y= (AKX L1-x)
Where Y=output
K=Capital
L=Labour
A, ∞=positive constant
Assumptions:
It has the following assumptions
1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a linear function of the
logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
ISOQUANTS:
The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quent’ implies quantity.
Isoquant therefore, means equal quantity. A family of iso-product curves or isoquants or production difference
curves can represent a production function with two variable inputs, which are substitutable for one another within
limits.
Iqoquants are the curves, which represent the different combinations of inputs producing a particular quantity of
output. Any combination on the isoquant represents the some level of output.
For a given output level firm’s production become,
Q= f (L, K)
Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.
Thus an isoquant shows all possible combinations of two inputs, which are capable of producing equal or a given
level of output. Since each combination yields same output, the producer becomes indifferent towards these
combinations.
Assumptions:
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.
An isoquant may be explained with the help of an arithmetical example.
Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50
Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’ quintals of a product all other
combinations in the table are assumed to yield the same given output of a product say ‘50’ quintals by employing
any one of the alternative combinations of the two factors labour and capital. If we plot all these combinations on
a paper and join them, we will get continues and smooth curve called Iso-product curve as shown below.
Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows all the alternative
combinations A, B, C, D, E which can produce 50 quintals of a product.
Producer’s Equilibrium:
The tem producer’s equilibrium is the counter part of consumer’s equilibrium. Just as the consumer is in
equilibrium when be secures maximum satisfaction, in the same manner, the producer is in equilibrium when he
secures maximum output, with the least cost combination of factors of production.
The optimum position of the producer can be found with the help of iso-product curve. The Iso-product curve or
equal product curve or production indifference curve shows different combinations of two factors of production,
which yield the same output. This is illustrated as follows.
Let us suppose. The producer can produces the given output of paddy say 100 quintals by employing any one of
the following alternative combinations of the two factors labour and capital computation of least cost combination
of two inputs.
L K Q L&LP (3Rs.) KXKP(4Rs.) Total cost

Units Units Output Cost of labour cost of capital
10 45 100 30 180 210
20 28 100 60 112 172
30 16 100 90 64 154
40 12 100 120 48 168
50 8 100 150 32 182
It is clear from the above that 10 units of ‘L’ combined with 45 units of ‘K’ would cost the producer Rs. 20/-. But
if 17 units reduce ‘K’ and 10 units increase ‘L’, the resulting cost would be Rs. 172/-. Substituting 10 more units
of ‘L’ for 12 units of ‘K’ further reduces cost pf Rs. 154/-/ However, it will not be profitable to continue this
substitution process further at the existing prices since the rate of substitution is diminishing rapidly. In the above
table the least cost combination is 30 units of ‘L’ used with 16 units of ‘K’ when the cost would be minimum at
Rs. 154/-. So this is they stage “the producer is in equilibrium”.
LAW OF PRODUCTION:
Production analysis in economics theory considers two types of input-output relationships.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
i) Law of variable proportions

ii) Law of returns to scale
I. Law of variable proportions:
The law of variable proportions which is a new name given to old classical concept of “Law of diminishing
returns has played a vital role in the modern economics theory. Assume that a firms production function consists
of fixed quantities of all inputs (land, equipment, etc.) except labour which is a variable input when the firm
expands output by employing more and more labour it alters the proportion between fixed and the variable inputs.
The law can be stated as follows:
“When total output or production of a commodity is increased by adding units of a variable input while the
quantities of other inputs are held constant, the increase in total production becomes after some point, smaller and
smaller”.
“If equal increments of one input are added, the inputs of other production services being held constant, beyond a
certain point the resulting increments of product will decrease i.e. the marginal product will diminish”. (G.
Stigler)
“As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then
the average product of that factor will diminish”. (F. Benham)
The law of variable proportions refers to the behaviour of output as the quantity of one Factor is increased
Keeping the quantity of other factors fixed and further it states that the marginal product and average product will
eventually do cline. This law states three types of productivity an input factor – Total, average and marginal
physical productivity.
Assumptions of the Law: The law is based upon the following assumptions:
i) The state of technology remains constant. If there is any improvement in technology, the average and
marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This law does not apply
to those cases where the factors must be used in rigidly fixed proportions.
iii) All units of the variable factors are homogenous.
Three stages of law:
The behaviors of the Output when the varying quantity of one factor is combines with a fixed quantity of the other
can be divided in to three district stages. The three stages can be better understood by following the table.
Fixed factor Variable factor Total product Average Product Marginal Product
(Labour)
1 1 100 100 - Stage I
1 2 220 120 120
1 3 270 90 50
1 4 300 75 30 Stage II
1 5 320 64 20
1 6 330 55 10
1 7 330 47 0 Stage
1 8 320 40 -10 III
Above table reveals that both average product and marginal product increase in the beginning and then decline of
the two marginal products drops of faster than average product. Total product is maximum when the farmer
employs 6th worker, nothing is produced by the 7th worker and its marginal productivity is zero, whereas marginal
product of 8th worker is ‘-10’, by just creating credits 8th worker not only fails to make a positive contribution but
leads to a fall in the total output.
Production function with one variable input and the remaining fixed inputs is illustrated as below
From the above graph the law of variable proportions operates in three stages. In the first stage, total product
increases at an increasing rate. The marginal product in this stage increases at an increasing rate resulting in a
greater increase in total product. The average product also increases. This stage continues up to the point where
average product is equal to marginal product. The law of increasing returns is in operation at this stage. The law of
diminishing returns starts operating from the second stage awards. At the second stage total product increases only
at a diminishing rate. The average product also declines. The second stage comes to an end where total product
becomes maximum and marginal product becomes zero. The marginal product becomes negative in the third
stage. So the total product also declines. The average product continues to decline.
We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more than “ A. P; When ‘A. P.” is
maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’ when ‘A. P.’ starts falling, ‘M. P.’ falls faster than ‘ A.
P.’.
Thus, the total product, marginal product and average product pass through three phases, viz., increasing
diminishing and negative returns stage. The law of variable proportion is nothing but the combination of the law
of increasing and demising returns.
II. Law of Returns of Scale:
The law of returns to scale explains the behavior of the total output in response to change in the scale of the firm,
i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in response to a simultaneous and
proportional increase in all the inputs. More precisely, the Law of returns to scale explains how a simultaneous
and proportionate increase in all the inputs affects the total output at its various levels.
The concept of variable proportions is a short-run phenomenon as in these period fixed factors can not be changed
and all factors cannot be changed. On the other hand in the long-term all factors can be changed as made variable.
When we study the changes in output when all factors or inputs are changed, we study returns to scale. An
increase in the scale means that all inputs or factors are increased in the same proportion. In variable proportions,
the cooperating factors may be increased or decreased and one faster (Ex. Land in agriculture (or) machinery in
industry) remains constant so that the changes in proportion among the factors result in certain changes in output.
In returns to scale all the necessary factors or production are increased or decreased to the same extent so that
whatever the scale of production, the proportion among the factors remains the same.
When a firm expands, its scale increases all its inputs proportionally, then technically there are three possibilities.
(i) The total output may increase proportionately (ii) The total output may increase more than proportionately and
(iii) The total output may increase less than proportionately. If increase in the total output is proportional to the
increase in input, it means constant returns to scale. If increase in the output is greater than the proportional
increase in the inputs, it means increasing return to scale. If increase in the output is less than proportional
increase in the inputs, it means diminishing returns to scale.
Let us now explain the laws of returns to scale with the help of isoquants for a two-input and single output
production system.
ECONOMIES OF SCALE
Production may be carried on a small scale or o a large scale by a firm. When a firm expands its size of production
by increasing all the factors, it secures certain advantages known as economies of production. Marshall has
classified these economies of large-scale production into internal economies and external economies.
Internal economies are those, which are opened to a single factory or a single firm independently of the action of
other firms. They result from an increase in the scale of output of a firm and cannot be achieved unless output
increases. Hence internal economies depend solely upon the size of the firm and are different for different firms.
External economies are those benefits, which are shared in by a number of firms or industries when the scale of
production in an industry or groups of industries increases. Hence external economies benefit all firms within the
industry as the size of the industry expands.
Causes of internal economies:

Internal economies are generally caused by two factors
1. Indivisibilities 2. Specialization.
1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a fixed minimum size. For
instance, if a worker works half the time, he may be paid half the salary. But he cannot be chopped into half and
asked to produce half the current output. Thus as output increases the indivisible factors which were being used
below capacity can be utilized to their full capacity thereby reducing costs. Such indivisibilities arise in the case of
labour, machines, marketing, finance and research.
2. Specialization.
Division of labour, which leads to specialization, is another cause of internal economies. Specialization refers to
the limitation of activities within a particular field of production. Specialization may be in labour, capital,
machinery and place. For example, the production process may be split into four departments relation to
manufacturing, assembling, packing and marketing under the charge of separate managers who may work under
the overall charge of the general manger and coordinate the activities of the for departments. Thus specialization
will lead to greater productive efficiency and to reduction in costs.
Internal Economies:
Internal economies may be of the following types.
A). Technical Economies.
Technical economies arise to a firm from the use of better machines and superior techniques of production. As a
result, production increases and per unit cost of production falls. A large firm, which employs costly and superior
plant and equipment, enjoys a technical superiority over a small firm. Another technical economy lies in the
mechanical advantage of using large machines. The cost of operating large machines is less than that of operating
mall machine. More over a larger firm is able to reduce it’s per unit cost of production by linking the various
processes of production. Technical economies may also be associated when the large firm is able to utilize all its
waste materials for the development of by-products industry. Scope for specialization is also available in a large
firm. This increases the productive capacity of the firm and reduces the unit cost of production.
B). Managerial Economies:
These economies arise due to better and more elaborate management, which only the large size firms can afford.
There may be a separate head for manufacturing, assembling, packing, marketing, general administration etc.
Each department is under the charge of an expert. Hence the appointment of experts, division of administration
into several departments, functional specialization and scientific co-ordination of various works make the
management of the firm most efficient.
C). Marketing Economies:
The large firm reaps marketing or commercial economies in buying its requirements and in selling its final
products. The large firm generally has a separate marketing department. It can buy and sell on behalf of the firm,
when the market trends are more favorable. In the matter of buying they could enjoy advantages like preferential
treatment, transport concessions, cheap credit, prompt delivery and fine relation with dealers. Similarly it sells its
products more effectively for a higher margin of profit.
D). Financial Economies:
The large firm is able to secure the necessary finances either for block capital purposes or for working capital
needs more easily and cheaply. It can barrow from the public, banks and other financial institutions at relatively
cheaper rates. It is in this way that a large firm reaps financial economies.
E). Risk bearing Economies:
The large firm produces many commodities and serves wider areas. It is, therefore, able to absorb any shock for
its existence. For example, during business depression, the prices fall for every firm. There is also a possibility for
market fluctuations in a particular product of the firm. Under such circumstances the risk-bearing economies or
survival economies help the bigger firm to survive business crisis.
F). Economies of Research:
A large firm possesses larger resources and can establish it’s own research laboratory and employ trained research
workers. The firm may even invent new production techniques for increasing its output and reducing cost.
G). Economies of welfare:
A large firm can provide better working conditions in-and out-side the factory. Facilities like subsidized canteens,
crèches for the infants, recreation room, cheap houses, educational and medical facilities tend to increase the
productive efficiency of the workers, which helps in raising production and reducing costs.
External Economies.
Business firm enjoys a number of external economies, which are discussed below:
A). Economies of Concentration:
When an industry is concentrated in a particular area, all the member firms reap some common economies like
skilled labour, improved means of transport and communications, banking and financial services, supply of power
and benefits from subsidiaries. All these facilities tend to lower the unit cost of production of all the firms in the
industry.
B). Economies of Information
The industry can set up an information centre which may publish a journal and pass on information regarding the
availability of raw materials, modern machines, export potentialities and provide other information needed by the
firms. It will benefit all firms and reduction in their costs.
C). Economies of Welfare:
An industry is in a better position to provide welfare facilities to the workers. It may get land at concessional rates
and procure special facilities from the local bodies for setting up housing colonies for the workers. It may also
establish public health care units, educational institutions both general and technical so that a continuous supply of
skilled labour is available to the industry. This will help the efficiency of the workers.
D). Economies of Disintegration:
The firms in an industry may also reap the economies of specialization. When an industry expands, it becomes
possible to spilt up some of the processes which are taken over by specialist firms. For example, in the cotton
textile industry, some firms may specialize in manufacturing thread, others in printing, still others in dyeing, some
in long cloth, some in dhotis, some in shirting etc. As a result the efficiency of the firms specializing in different
fields increases and the unit cost of production falls.
Thus internal economies depend upon the size of the firm and external economies depend upon the size of the
industry.
DISECONOMIES OF LARGE SCALE PRODUCTION
Internal and external diseconomies are the limits to large-scale production. It is possible that expansion of a firm’s
output may lead to rise in costs and thus result diseconomies instead of economies. When a firm expands beyond
proper limits, it is beyond the capacity of the manager to manage it efficiently. This is an example of an internal
diseconomy. In the same manner, the expansion of an industry may result in diseconomies, which may be called
external diseconomies. Employment of additional factors of production becomes less efficient and they are
obtained at a higher cost. It is in this way that external diseconomies result as an industry expands.
The major diseconomies of large-scale production are discussed below:
Internal Diseconomies:
A). Financial Diseconomies:
For expanding business, the entrepreneur needs finance. But finance may not be easily available in the required
amount at the appropriate time. Lack of finance retards the production plans thereby increasing costs of the firm.
B). Managerial diseconomies:
There are difficulties of large-scale management. Supervision becomes a difficult job. Workers do not work
efficiently, wastages arise, decision-making becomes difficult, coordination between workers and management
disappears and production costs increase.
C). Marketing Diseconomies:
As business is expanded, prices of the factors of production will rise. The cost will therefore rise. Raw materials
may not be available in sufficient quantities due to their scarcities. Additional output may depress the price in the
market. The demand for the products may fall as a result of changes in tastes and preferences of the people. Hence
cost will exceed the revenue.
D). Technical Diseconomies:
There is a limit to the division of labour and splitting down of production p0rocesses. The firm may fail to operate
its plant to its maximum capacity. As a result cost per unit increases. Internal diseconomies follow.
E). Diseconomies of Risk-taking:
As the scale of production of a firm expands risks also increase with it. Wrong decision by the management may
adversely affect production. In large firms are affected by any disaster, natural or human, the economy will be put
to strains.
External Diseconomies:
When many firm get located at a particular place, the costs of transportation increases due to congestion. The
firms have to face considerable delays in getting raw materials and sending finished products to the marketing
centers. The localization of industries may lead to scarcity of raw material, shortage of various factors of
production like labour and capital, shortage of power, finance and equipments. All such external diseconomies
tend to raise cost per unit.
QUESTIONS
1. Why does the law of diminishing returns operate? Explain with the help of a diagram.
2. Explain the nature and uses of production function.
3. Explain and illustrate lows of returns to scale.
4. a. Explain how production function can be mode use of to reduce cost of
Production.
b. Explain low of constant returns? Illustrate.
5. Explain the following (i) Internal Economics (ii) External Economics (or)
Explain Economics of scale. Explain the factor, which causes increasing returns to scale.
6. Explain the following with reference to production functions
(a) MRTS
(b) Variable proportion of factor
7. Define production function, explain is equate and is cost curves.
8. Explain the importance and uses of production function in break-even analysis.
9. Discuss the equilibrium of a firm with isoquants.
10. (a) What are isocost curves and iso quants? Do they interest each other
(b) Explain Cobb-Douglas Production function.
QUIZ
1. How many types of input-output relations discussed by the

Law of production. ( )
(a) Five (b) Four

(c) Two (d) Three
2. How many stages are there in ‘Law of Variable Proportions’? ( )
(a) Five (b) Two
(c) Three (d) Four
3. Congregation of body of persons assembling together to work at a certain

Time and place is called as ( )
(a) Firm (b) Industry
(c) Plant (d) Size
4. When a firm expands its Size of production by increasing all factors,

It secures certain advantages, known as ( )
(a) Optimum Size (b) Diseconomies of Scale
(c) Economies of Scale (d) None
5. When producer secures maximum output with the least cost combination
Of factors of production, it is known as_______ ( )
(a) Consumer’s Equilibrium (b) Price Equilibrium
(c) Producer’s Equilibrium (d) Firm’s Equilibrium
6. The ‘Law of Variable Proportions’ is also called as ____________. ( )

(a) Law of fixed proportions (b) Law of returns to scale
(c) Law of variable proportions (d) None
7. _________ Is a ‘group of firms producing the same are slightly

Different products for the same market or using same raw material’. ( )
(a) Plant (b) Firm
(c) Industry (d) Size
8. When proportionate increase in all inputs results in an equal

Proportionate increase in output, then we call____________. ( )
(a) Increasing Returns to Scale (b) Decreasing Returns to Scale
(c) Constant Returns to Scale (d) None
9. When different combinations of inputs yield the same level of output

Known as ___________. ( )
(a) Different Quants (b) Output differentiation
(c) Isoquants (d) Production differentiation
10. Conversion of inputs in to output is called as _________________. ( )

(a) Sales (b) Income
(c) Production (d) Expenditure
11. When Proportionate increase in all inputs results in more than equal
Proportionate increase in output, then we call _____________. ( )
(a) Decreasing Returns to Scale (b) Constant Returns to Scale
(c) Increasing Returns to Scale (d) None
12. When Proportionate increase in all inputs results in less than Equal
Proportionate increase in output, then we call _____________. ( )
(a) Increasing Returns to Scale (b) Constant Returns to Scale
(c) Decreasing Returns to Scale (d) None
13. A curve showing equal amount of outlay with varying Proportions of

Two inputs are called ________________. ( )
(a) Total Cost Curve (b) Variable Cost Curve

(c) Isocost Curve (d) Marginal Cost Curve
Note: Answer is “C” for all the above questions.
COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its ability to earn
sustained profits. Profits are the difference between selling price and cost of production. In general the selling
price is not within the control of a firm but many costs are under its control. The firm should therefore aim at
controlling and minimizing cost. Since every business decision involves cost consideration, it is necessary to
understand the meaning of various concepts for clear business thinking and application of right kind of costs.
COST CONCEPTS:
A managerial economist must have a clear understanding of the different cost concepts for clear business thinking
and proper application. The several alternative bases of classifying cost and the relevance of each for different
kinds of problems are to be studied. The various relevant concepts of cost are:
1. Opportunity costs and outlay costs:
Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred by the firm
these are the payments made for labour, material, plant, building, machinery traveling, transporting etc., These are
all those expense item appearing in the books of account, hence based on accounting cost concept.
On the other hand opportunity cost implies the earnings foregone on the next best alternative, has the present
option is undertaken. This cost is often measured by assessing the alternative, which has to be scarified if the
particular line is followed.
The opportunity cost concept is made use for long-run decisions. This concept is very important in capital
expenditure budgeting. This concept is very important in capital expenditure budgeting. The concept is also useful
for taking short-run decisions opportunity cost is the cost concept to use when the supply of inputs is strictly
limited and when there is an alternative. If there is no alternative, Opportunity cost is zero. The opportunity cost of
any action is therefore measured by the value of the most favorable alternative course, which had to be foregoing
if that action is taken.
2. Explicit and implicit costs:
Explicit costs are those expenses that involve cash payments. These are the actual or business costs that appear in
the books of accounts. These costs include payment of wages and salaries, payment for raw-materials, interest on
borrowed capital funds, rent on hired land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. These costs are not actually
incurred but would have been incurred in the absence of employment of self – owned factors. The two normal
implicit costs are depreciation, interest on capital etc. A decision maker must consider implicit costs too to find
out appropriate profitability of alternatives.
3. Historical and Replacement costs:
Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as the original
price paid for the asset acquired in the past. Historical valuation is the basis for financial accounts.
A replacement cost is the price that would have to be paid currently to replace the same asset. During periods of
substantial change in the price level, historical valuation gives a poor projection of the future cost intended for
managerial decision. A replacement cost is a relevant cost concept when financial statements have to be adjusted
for inflation.
4. Short – run and long – run costs:
Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in output during
this period is possible only by using the existing physical capacity more extensively. So short run cost is that
which varies with output when the plant and capital equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including plant and capital
equipment. Long-run cost analysis helps to take investment decisions.
5. Out-of pocket and books costs:
Out-of pocket costs also known as explicit costs are those costs that involve current cash payment. Book costs
also called implicit costs do not require current cash payments. Depreciation, unpaid interest, salary of the owner
is examples of back costs.
But the book costs are taken into account in determining the level dividend payable during a period. Both book
costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-owned factors of
production.
6. Fixed and variable costs:
Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the changes in the
volume of production. But fixed cost per unit decrease, when the production is increased. Fixed cost includes
salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output results in an increase
in total variable costs and decrease in total output results in a proportionate decline in the total variables costs. The
variable cost per unit will be constant. Ex: Raw materials, labour, direct expenses, etc.
7. Post and Future costs:
Post costs also called historical costs are the actual cost incurred and recorded in the book of account these costs
are useful only for valuation and not for decision making.
Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They are the costs
forecasted or estimated with rational methods. Future cost estimate is useful for decision making because decision
are meant for future.
8. Traceable and common costs:
Traceable costs otherwise called direct cost, is one, which can be identified with a products process or product.
Raw material, labour involved in production is examples of traceable cost.
Common costs are the ones that common are attributed to a particular process or product. They are incurred
collectively for different processes or different types of products. It cannot be directly identified with any
particular process or type of product.
9. Avoidable and unavoidable costs:
Avoidable costs are the costs, which can be reduced if the business activities of a concern are curtailed. For
example, if some workers can be retrenched with a drop in a product – line, or volume or production the wages of
the retrenched workers are escapable costs.
The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this cost even if
reduction in business activity is made. For example cost of the ideal machine capacity is unavoidable cost.
10. Controllable and uncontrollable costs:
Controllable costs are ones, which can be regulated by the executive who is in change of it. The concept of
controllability of cost varies with levels of management. Direct expenses like material, labour etc. are controllable
costs.
Some costs are not directly identifiable with a process of product. They are appointed to various processes or
products in some proportion. This cost varies with the variation in the basis of allocation and is independent of the
actions of the executive of that department. These apportioned costs are called uncontrollable costs.
11. Incremental and sunk costs:
Incremental cost also known as different cost is the additional cost due to a change in the level or nature of
business activity. The change may be caused by adding a new product, adding new machinery, replacing a
machine by a better one etc.
Sunk costs are those which are not altered by any change – They are the costs incurred in the past. This cost is the
result of past decision, and cannot be changed by future decisions. Investments in fixed assets are examples of
sunk costs.
12. Total, average and marginal costs:
Total cost is the total cash payment made for the input needed for production. It may be explicit or implicit. It is
the sum total of the fixed and variable costs. Average cost is the cost per unit of output. If is obtained by dividing
the total cost (TC) by the total quantity produced (Q)
TC
Average cost = ------
Q
Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost of the
marginal unit produced.
13. Accounting and Economics costs:
Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit and ton
statements to meet the legal, financial and tax purpose of the company. The accounting concept is a historical
concept and records what has happened in the post.
Economics concept considers future costs and future revenues, which help future planning, and choice, while the
accountant describes what has happened, the economics aims at projecting what will happen.
COST-OUTPUT RELATIONSHIP
A proper understanding of the nature and behavior of costs is a must for regulation and control of cost of
production. The cost of production depends on money forces and an understanding of the functional relationship
of cost to various forces will help us to take various decisions. Output is an important factor, which influences the
cost.
The cost-output relationship plays an important role in determining the optimum level of production. Knowledge
of the cost-output relation helps the manager in cost control, profit prediction, pricing, promotion etc. The relation
between cost and its determinants is technically described as the cost function.
C= f (S, O, P, T ….)
Where;
C= Cost (Unit or total cost)
S= Size of plant/scale of production
O= Output level
P= Prices of inputs
T= Technology
Considering the period the cost function can be classified as (a) short-run cost function and (b) long-run cost
function. In economics theory, the short-run is defined as that period during which the physical capacity of the
firm is fixed and the output can be increased only by using the existing capacity allows to bring changes in output
by physical capacity of the firm.
(a) Cost-Output Relation in the short-run:
The cost concepts made use of in the cost behavior are total cost, Average cost, and marginal cost.
Total cost is the actual money spent to produce a particular quantity of output. Total cost is the summation of
fixed and variable costs.
TC=TFC+TVC
Up to a certain level of production total fixed cost i.e., the cost of plant, building, equipment etc, remains fixed.
But the total variable cost i.e., the cost of labour, raw materials etc., Vary with the variation in output. Average
cost is the total cost per unit. It can be found out as follows.
AC=
TC
Q
Q
The total of average fixed cost (TFC/Q) keep coming down as the production is increased and average variable
cost (TVC/Q) will remain constant at any level of output.
Marginal cost is the addition to the total cost due to the production of an additional unit of product. It can be
arrived at by dividing the change in total cost by the change in total output.
In the short-run there will not be any change in total fixed cost. Hence change in total cost implies change in total
variable cost only.
Cost – output relations
Units of Total Total Total cost Average Average Average Marginal

Output Q fixed cost variable (TFC + variable fixed cost cost cost MC
TFC cost TVC TVC) TC cost (TVC (TFC / Q) (TC/Q)
/ Q) AVC AFC AC
0 - - 60 - - - -
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42
The above table represents the cost-output relation. The table is prepared on the basis of the law of diminishing
marginal returns. The fixed cost Rs. 60 May include rent of factory building, interest on capital, salaries of
permanently employed staff, insurance etc. The table shows that fixed cost is same at all levels of output but the
average fixed cost, i.e., the fixed cost per unit, falls continuously as the output increases. The expenditure on the
variable factors (TVC) is at different rate. If more and more units are produced with a given physical capacity the
AVC will fall initially, as per the table declining up to 3rd unit, and being constant up to 4th unit and then rising. It
implies that variable factors produce more efficiently near a firm’s optimum capacity than at any other levels of
output.
And later rises. But the rise in AC is felt only after the start rising. In the table ‘AVC’ starts rising from the 5th unit
onwards whereas the ‘AC’ starts rising from the 6th unit only so long as ‘AVC’ declines ‘AC’ also will decline.
‘AFC’ continues to fall with an increase in Output. When the rise in ‘AVC’ is more than the decline in ‘AFC’, the
total cost again begin to rise. Thus there will be a stage where the ‘AVC’, the total cost again begin to rise thus
there will be a stage where the ‘AVC’ may have started rising, yet the ‘AC’ is still declining because the rise in
‘AVC’ is less than the droop in ‘AFC’.
Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing returns or
diminishing cost in the second stage and followed by diminishing returns or increasing cost in the third stage.
The short-run cost-output relationship can be shown graphically as follows.
In the above graph the “AFC’ curve continues to fall as output rises an account of its spread over more and more
units Output. But AVC curve (i.e. variable cost per unit) first falls and than rises due to the operation of the law of
variable proportions. The behavior of “ATC’ curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve.
In the initial stage of production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a certain
point ‘AVC’ starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC will still continue to
decline otherwise AC begins to rise. Thus the lower end of ‘ATC’ curve thus turns up and gives it a U-shape. That
is why ‘ATC’ curve are U-shaped. The lowest point in ‘ATC’ curve indicates the least-cost combination of inputs.
Where the total average cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the
maximum output level rather it is the point where per unit cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:
1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
a. ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
b. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
c. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
b. Cost-output Relationship in the long-run:
Long run is a period, during which all inputs are variable including the one, which are fixes in the short-run. In the
long run a firm can change its output according to its demand. Over a long period, the size of the plant can be
changed, unwanted buildings can be sold staff can be increased or reduced. The long run enables the firms to
expand and scale of their operation by bringing or purchasing larger quantities of all the inputs. Thus in the long
run all factors become variable.
The long-run cost-output relations therefore imply the relationship between the total cost and the total output. In
the long-run cost-output relationship is influenced by the law of returns to scale.
In the long run a firm has a number of alternatives in regards to the scale of operations. For each scale of
production or plant size, the firm has an appropriate short-run average cost curves. The short-run average cost
(SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in to consideration
many plants.
The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.
To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure it is assumed that
technologically there are only three sizes of plants – small, medium and large, ‘SAC’, for the small size, ‘SAC2’
for the medium size plant and ‘SAC3’ for the large size plant. If the firm wants to produce ‘OP’ units of output, it
will choose the smallest plant. For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It does
not mean that the OQ production is not possible with small plant. Rather it implies that cost of production will be
more with small plant compared to the medium plant.
For an output ‘OR’ the firm will choose the largest plant as the cost of production will be more with medium
plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to the entire family
of ‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’ curve at one point, and thus it is known as envelope
curve. It is also known as planning curve as it serves as guide to the entrepreneur in his planning to expand the
production in future. With the help of ‘LAC’ the firm determines the size of plant which yields the lowest average
cost of producing a given volume of output it anticipates.
BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted in two senses.
In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total revenue is equal to total
cost. It is the point of no profit, no loss. In its broad determine the probable profit at any level of production.
Assumptions:
1. All costs are classified into two – fixed and variable.

2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains constant.
Merits:
1. Information provided by the Break Even Chart can be understood more easily then those contained in the
profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how changes in
profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material, direct labour,
fixed and variable overheads.
Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations such as capital
amount, marketing aspects and effect of government policy etc., which are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In actual practice,
this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may increase the profit
without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may be opening stock.
10. When production increases variable cost per unit may not remain constant but may reduce on account of
bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known defect of BEC.
1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point
1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed expenses. Eg.
Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed changes are fixed only within a
certain range of plant capacity. The concept of fixed overhead is most useful in formulating a price fixing
policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production of sales are called
variable expenses. Eg. Electric power and fuel, packing materials consumable stores. It should be noted that
variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it contributed towards fixed
costs and profit. It helps in sales and pricing policies and measuring the profitability of different proposals.
Contribution is a sure test to decide whether a product is worthwhile to be continued among different
products.
Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be expressed in
absolute sales amount or in percentage. It indicates the extent to which the sales can be reduced without
resulting in loss. A large margin of safety indicates the soundness of the business. The formula for the margin
of safety is:
Profit
Present sales – Break even sales or
P. V. ratio
Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.
5. Angle of incidence: This is the angle between sales line and total cost line at the Break-even point. It
indicates the profit earning capacity of the concern. Large angle of incidence indicates a high rate of profit; a
small angle indicates a low rate of earnings. To improve this angle, contribution should be increased either by
raising the selling price and/or by reducing variable cost. It also indicates as to what extent the output and
sales price can be changed to attain a desired amount of profit.
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for studying the
profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in percentage.
Therefore, every organization tries to improve the P. V. ratio of each product by reducing the variable cost per
unit or by increasing the selling price per unit. The concept of P. V. ratio helps in determining break even-
point, a desired amount of profit etc.
Contribution
The formula is, X 100
Sales
7. Break – Even- Point: If we divide the term into three words, then it does not require further explanation.
Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a point of no profit, no
loss. This is also a minimum point of no profit, no loss. This is also a minimum point of production
where total costs are recovered. If sales go up beyond the Break Even Point, organization makes a profit.
If they come down, a loss is incurred.
Fixed Expenses
1. Break Even point (Units) =
Contribution per unit
Fixed expenses
2. Break Even point (In Rupees) = X sales
Contribution
UNIT – III
INTRODUCTION TO MARKET AND PRICING STRATEGIES
Pricing
Introduction
Pricing is an important, if not the most important function of all enterprises. Since every enterprise is engaged in
the production of some goods or/and service. Incurring some expenditure, it must set a price for the same to sell it
in the market. It is only in extreme cases that the firm has no say in pricing its product; because there is severe or
rather perfect competition in the market of the good happens to be of such public significance that its price is
decided by the government. In an overwhelmingly large number of cases, the individual producer plays the role in
pricing its product.
It is said that if a firm were good in setting its product price it would certainly flourish in the market. This is
because the price is such a parameter that it exerts a direct influence on the products demand as well as on its
supply, leading to firm’s turnover (sales) and profit. Every manager endeavors to find the price, which would best
meet with his firm’s objective. If the price is set too high the seller may not find enough customers to buy his
product. On the other hand, if the price is set too low the seller may not be able to recover his costs. There is a
need for the right price further, since demand and supply conditions are variable over time what is a right price
today may not be so tomorrow hence, pricing decision must be reviewed and reformulated from time to time.
Price
Price denotes the exchange value of a unit of good expressed in terms of money. Thus the current price of a maruti
car around Rs. 2,00,000, the price of a hair cut is Rs. 25 the price of a economics book is Rs. 150 and so on.
Nevertheless, if one gives a little, if one gives a little thought to this subject, one would realize that there is
nothing like a unique price for any good. Instead, there are multiple prices.
Price concepts
Price of a well-defined product varies over the types of the buyers, place it is received, credit sale or cash sale,
time taken between final production and sale, etc.
It should be obvious to the readers, that the price difference on account of the above four factors are more
significant. The multiple prices is more serious in the case of items like cars refrigerators, coal, furniture and
bricks and is of little significance for items like shaving blade, soaps, tooth pastes, creams and stationeries.
Differences in various prices of any good are due to differences in transport cost, storage cost accessories, interest
cost, intermediaries’ profits etc. Once can still conceive of a basic price, which would be exclusive of all these
items of cost and then rationalize other prices by adding the cost of special items attached to the particular
transaction, in what follows we shall explain the determination of this basis price alone and thus resolve the
problem of multiple prices.
Price determinants – Demand and supply
The price of a product is determined by the demand for and supply of that product. According to Marshall the role
of these two determinants is like that of a pair of scissors in cutting cloth. It is possible that at times, while one
pair is held fixed, the other is moving to cut the cloth. Similarly, it is conceivable that there could be situations
under which either demand or supply is playing a passive role, and the other, which is active, alone appear to be
determining the price. However, just as one pair of scissors alone can never cut a cloth, demand or supply alone is
insufficient to determine the price.
Equilibrium Price
The price at which demand and supply of a commodity is equal known as equilibrium price. The demand and
supply schedules of a good are shown in the table below.
Demand supply schedule
Price Demand Supply

50 100 200
40 120 180
30 150 150
20 200 110
10 300 50
Of the five possible prices in the above example, price Rs.30 would be the market-clearing price. No other price
could prevail in the market. If price is Rs. 50 supply would exceed demand and consequently the producers of this
good would not find enough customers for their demand, thereby they would accumulate unwanted inventories of
output, which, in turn, would lead to competition among the producers, forcing price to Rs.30. Similarly if price
were Rs.10, there would be excess demand, which would give rise to competition among the buyers of good,
forcing price to Rs.30. At price Rs.30, demand equals supply and thus both producers and consumers are satisfied.
The economist calls such a price as equilibrium price.
It was seen in unit 1 that the demand for a good depends on, a number of factors and thus, every factor, which
influences either demand or supply is in fact a determinant of price. Accordingly, a change in demand or/and
supply causes price change.
MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer of
ownership occurs. A market may be also defined as the demand made by a certain group of potential buyers for a
good or service. The former one is a narrow concept and later one, a broader concept. Economists describe a
market as a collection of buyers and sellers who transact over a particular product or product class (the housing
market, the clothing market, the grain market etc.). For business purpose we define a market as people or
organizations with wants (needs) to satisfy, money to spend, and the willingness to spend it. Broadly, market
represents the structure and nature of buyers and sellers for a commodity/service and the process by which the
price of the commodity or service is established. In this sense, we are referring to the structure of competition and
the process of price determination for a commodity or service. The determination of price for a commodity or
service depends upon the structure of the market for that commodity or service (i.e., competitive structure of the
market). Hence the understanding on the market structure and the nature of competition are a pre-requisite in price
determination.
Different Market Structures
Market structure describes the competitive environment in the market for any good or service. A market consists
of all firms and individuals who are willing and able to buy or sell a particular product. This includes firms and
individuals currently engaged in buying and selling a particular product, as well as potential entrants.
The determination of price is affected by the competitive structure of the market. This is because the firm operates
in a market and not in isolation. In marking decisions concerning economic variables it is affected, as are all
institutions in society by its environment.
Perfect Competition
Perfect competition refers to a market structure where competition among the sellers and buyers prevails in its
most perfect form. In a perfectly competitive market, a single market price prevails for the commodity, which is
determined by the forces of total demand and total supply in the market.
Characteristics of Perfect Competition
The following features characterize a perfectly competitive market:
1. A large number of buyers and sellers: The number of buyers and sellers is large and the share of each
one of them in the market is so small that none has any influence on the market price.
2. Homogeneous product: The product of each seller is totally undifferentiated from those of the others.
3. Free entry and exit: Any buyer and seller is free to enter or leave the market of the commodity.
4. Perfect knowledge: All buyers and sellers have perfect knowledge about the market for the commodity.
5. Indifference: No buyer has a preference to buy from a particular seller and no seller to sell to a particular
buyer.
6. Non-existence of transport costs: Perfectly competitive market also assumes the non-existence of
transport costs.
7. Perfect mobility of factors of production: Factors of production must be in a position to move freely into
or out of industry and from one firm to the other.
Under such a market no single buyer or seller plays a significant role in price determination. One the other hand
all of them jointly determine the price. The price is determined in the industry, which is composed of all the
buyers and seller for the commodity. The demand curve facing the industry is the sum of all consumers’ demands
at various prices. The industry supply curve is the sum of all sellers’ supplies at various prices.
Pure competition and perfect competition
The term perfect competition is used in a wider sense. Pure competition has only limited assumptions. When the
assumptions, that large number of buyers and sellers, homogeneous products, free entry and exit are satisfied,
there exists pure competition. Competition becomes perfect only when all the assumptions (features) are satisfied.
Generally pure competition can be seen in agricultural products.
Equilibrium of a firm and industry under perfect competition
Equilibrium is a position where the firm has no incentive either to expand or contrast its output. The firm is said to
be in equilibrium when it earn maximum profit. There are two conditions for attaining equilibrium by a firm. They
are:
Marginal cost is an additional cost incurred by a firm for producing and additional unit of output. Marginal
revenue is the additional revenue accrued to a firm when it sells one additional unit of output. A firm increases its
output so long as its marginal cost becomes equal to marginal revenue. When marginal cost is more than marginal
revenue, the firm reduces output as its costs exceed the revenue. It is only at the point where marginal cost is
equal to marginal revenue, and then the firm attains equilibrium. Secondly, the marginal cost curve must cut the
marginal revenue curve from below. If marginal cost curve cuts the marginal revenue curve from above, the firm
is having the scope to increase its output as the marginal cost curve slopes downwards. It is only with the upward
sloping marginal cost curve, there the firm attains equilibrium. The reason is that the marginal cost curve when
rising cuts the marginal revenue curve from below.
The equilibrium of a perfectly competitive firm may be explained with the help of the fig. 6.2.
In the given fig. PL and MC represent the Price line and Marginal cost curve. PL also represents Marginal
revenue, Average revenue and demand. As Marginal revenue, Average revenue and demand are the same in
perfect competition, all are equal to the price line. Marginal cost curve is U- shaped curve cutting MR curve at R
and T. At point R marginal cost becomes equal to marginal revenue. But MC curve cuts the MR curve fro above.
So this is not the equilibrium position. The downward sloping marginal cost curve indicates that the firm can
reduce its cost of production by increasing output. As the firm expands its output, it will reach equilibrium at point
T. At this point, on price line PL; the two conditions of equilibrium are satisfied. Here the marginal cost and
marginal revenue of the firm remain equal. The firm is producing maximum output and is in equilibrium at this
stage. If the firm continues its output beyond this stage, its marginal cost exceeds marginal revenue resulting in
losses. As the firm has no idea of expanding or contracting its size of out, the firm is said to be in equilibrium at
point T.
Pricing under perfect competition
The price or value of a commodity under perfect competition is determined by the demand for and the supply of
that commodity.
Under perfect competition there is large number of sellers trading in a homogeneous product. Each firm supplies
only very small portion of the market demand. No single buyer or seller is powerful enough to influence the price.
The demand of all consumers and the supply of all firms together determine the price. The individual seller is only
a price taker and not a price maker. An individual firm has no price policy of it’s own. Thus, the main problem of
a firm in a perfectly competitive market is not to determine the price of its product but to adjust its output to the
given price, So that the profit is maximum. Marshall however gives great importance to the time element for the
determination of price. He divided the time periods on the basis of supply and ignored the forces of demand. He
classified the time into four periods to determine the price as follows.
1. Very short period or Market period

2. Short period
3. Long period
4. Very long period or secular period
Very short period: It is the period in which the supply is more or less fixed because the time available to the firm
to adjust the supply of the commodity to its changed demand is extremely short; say a single day or a few days.
The price determined in this period is known as Market Price.
Short Period: In this period, the time available to firms to adjust the supply of the commodity to its changed
demand is, of course, greater than that in the market period. In this period altering the variable factors like raw
materials, labour, etc can change supply. During this period new firms cannot enter into the industry.
Long period: In this period, a sufficiently long time is available to the firms to adjust the supply of the
commodity fully to the changed demand. In this period not only variable factors of production but also fixed
factors of production can be changed. In this period new firms can also enter the industry. The price determined in
this period is known as long run normal price.
Secular Period: In this period, a very long time is available to adjust the supply fully to change in demand. This
is very long period consisting of a number of decades. As the period is very long it is difficult to lay down
principles determining the price.
Price Determination in the market period
The price determined in very short period is known as Market price. Market price is determined by the
equilibrium between demand and supply in a market period. The nature of the commodity determines the nature
of supply curve in a market period. Under this period goods are classified in to (a) Perishable goods and (b) Non-
perishable goods.
Perishable Goods: In the very short period, the supply of perishable goods like fish, milk vegetables etc. cannot
be increased. And it cannot be decreased also. As a result the supply curve under very short period will be parallel
to the Y-axis or Vertical to X-axis. Supply is perfectly inelastic. The price determination of perishable goods in
very short period may be shown with the help of the following fig. 6.5
In this figure quantity is represented along X-axis and price is represented along Y-axis. MS is the very short
period supply curve of perishable goods. DD is demand curve. It intersects supply curve at E. The price is OP.
The quantity exchanged is OM. D1 D1 represents increased demand. This curve cuts the supply curve at E1. Even
at the new equilibrium, supply is OM only. But price increases to OP1. So, when demand increases, the price will
increase but not the supply. If demand decreases new demand curve will be D2 D2. This curve cuts the supply
curve at E2. Even at this new equilibrium, the supply is OM only. But price falls to OP2. Hence in very short
period, given the supply, it is the change in demand that influences price. The price determined in a very short
period is called Market Price.
Non-perishable goods: In the very short period, the supply of non-perishable goods like cloth, pen, watches etc.
cannot be increased. But if price falls, preserving some stock can decrease their supply. If price falls too much, the
whole stock will be held back from the market and carried over to the next market period. The price below, which
the seller will refuse to sell, is called Reserve Price.
The Price determination of non-perishable goods in very short period may be shown with the help of the following
fig 6.6.
In the given figure quantity is shown on X-axis and the price on Y-axis. SES is the supply curve. It slopes upward
up to the point E. From E it becomes a vertical straight line. This is because the quantity existing with sellers is
OM, the maximum amount they have is thus OM. Till OM quantity (i.e., point E) the supply curve sloped upward.
At the point S, nothing is offered for sale.
It means that the seller with hold the entire stock if the price is OS. OS is thus the reserve price. As the price rises,
supply increases up to point E. At OP price (Point E), the entire stock is offered for sale.
Suppose demand increases, the DD curve shift upward. It becomes D1D1 price raises to OP1. If demand
decreases, the demand curve becomes D2D2. It intersects the supply curve at E3. The price will fall to OP3. We
find that at OS price, supply is zero. It is the reserve price.
Price Determination in the short period
Short period is a period in which supply can be increased by altering the variable factors. In this period fixed costs
will remain constant. The supply is increased when price rises and vice versa. So the supply curve slopes upwards
from left to right.
The price in short period may be explained with the help of a diagram.
In the given diagram MPS is the market period supply curve. DD is the initial demand curve. It intersects MPS
curve at E. The price is OP and out put OM. Suppose demand increases, the demand curve shifts upwards and
becomes D1D1. In the very short period, supply remains fixed on OM. The new demand curve D1D1 intersects
MPS at E1. The price will rise to OP1. This is what happen in the very short-period.
As the price rises from OP to OP1, firms expand output. As firms can vary some factors but not all, the law of
variable proportions operates. This results in new short-run supply curve SPS. It interests D1 D1 curve at E4. The
price will fall from OP1 to OP4.
It the demand decreases, DD curve shifts downward and becomes D2D2. It interests MPS curve at E2. The price
will fall to OP2. This is what happens in market period. In the short period, the supply curve is SPS. D2D2 curve
interests SPS curve at E3. The short period price is higher than the market period price.
Price determination in the long period (Normal Price)
Market price may fluctuate due to a sudden change either on the supply side or on the demand side. A big arrival
of milk may decrease the price of that production in the market period. Similarly, a sudden cold wave may raise
the price of woolen garments. This type of temporary change in supply and demand may cause changes in market
price. In the absence of such disturbing causes, the price tends to come back to a certain level. Marshall called this
level is normal price level. In the words of Marshall Normal value (Price) of a commodity is that which
economics force would tend to bring about in the long period.
In order to describe how long run normal price is determined, it is useful to refer to the market period as short
period also. The market period is so short that no adjustment in the output can be made. Here cost of production
has no influence on price. A short period is sufficient only to allow the firms to make only limited output
adjustment. In the long period, supply conditions are fully sufficient to meet the changes in demand. In the long
period, all factors are alterable and the new firms may enter into or old firms leave the; industry.
In the long period all costs are variable costs. So supply will be increased only when price is equal to average cost.
Hence, in long period normal price will be equal to minimum average cost of the industry. Will this price be more
or less than the short period normal price? The answer depends on the stage of returns to which the industry is
subject. There are three stages of return on the stage of returns to which the industry is subject. There are three
stages of returns.
1. Increasing returns or decreasing costs.

2. Constant Returns or Constant costs.
3. Diminishing returns or increasing costs.
1. Determination of long period normal price in decreasing cost industry:
At this stage, average cost falls due to an increase in the output. So, the supply curve at this stage will
slope downwards from left to right. The long period Normal price determination at this stage can be
explained with the help of a diagram.
In the diagram, MPS represents market period supply curve. DD is demand curve. DD cuts LPS, SPS and
MPS at point E. At point E the supply is OM and the price is OP. If demand increases from DD to D1D1
market price increases to OP1. In the short period it is OP2. In the long period supply increases
considerably to OM3. So price has fallen to OP3, which is less than the price of market period.
2. Determination of Long Period Normal Price in Constant Cost Industry:
In this case average cost does not change even though the output increases. Hence long period
supply curve is horizontal to X-axis. The determination of long period normal price can be explained with
the help of the diagram. In the fig. 6.9, LPS is horizontal to X-axis. MPS represents market period supply
curve, and SPS represents short period supply curve. At point ‘E’ the output is OM and price is OP. If
demand increases from DD to D1D1 market price increases to OP1. In the short period, supply increases
and hence the price will be OP2. In the long run supply is adjusted fully to meet increased demand. The
price remains constant at OP because costs are constant at OP and market is perfect market.
3. Determination of long period normal price in increase cost industry:
If the industry is subject to increasing costs (diminishing returns) the supply curve slopes upwards from left to
right like an ordinary supply curve. The determination of long period normal price in increasing cost industry can
be explained with the help of the following diagram. In the diagram LPS represents long period supply curve. The
industry is subject to diminishing return or increasing costs. So, LPS slopes upwards from left to right. SPS is
short period supply curve and MPS is market period supply curve. DD is demand curve. It cuts all the supply
curves at E. Here the price is OP and output is OM. If demand increases from DD to D1D1 in the market period,
supply will not change but the price increases to OP1. In the short period, price increase but the price increases to
OP1. In the short period, price increases to OP2 as the supply increased from OM to OM2. In the long period
supply increases to OM3 and price increases to OP3. But this increase in price is less than the price increase in a
market period or short period.
Monopoly
The word monopoly is made up of two syllables, Mono and poly. Mono means single while poly implies selling.
Thus monopoly is a form of market organization in which there is only one seller of the commodity. There are no
close substitutes for the commodity sold by the seller. Pure monopoly is a market situation in which a single firm
sells a product for which there is no good substitute.
Features of monopoly
The following are the features of monopoly.
1. Single person or a firm: A single person or a firm controls the total supply of the commodity. There will
be no competition for monopoly firm. The monopolist firm is the only firm in the whole industry.
2. No close substitute: The goods sold by the monopolist shall not have closely competition substitutes.
Even if price of monopoly product increase people will not go in far substitute. For example: If the price
of electric bulb increase slightly, consumer will not go in for kerosene lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of buyers in the market who
compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a price-maker, and
then he can alter the price.
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix both. If he
charges a very high price, he can sell a small amount. If he wants to sell more, he has to charge a low
price. He cannot sell as much as he wishes for any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of monopolist slopes
downward from left to right. It means that he can sell more only by lowering price.
Types of Monopoly
Monopoly may be classified into various types. The different types of monopolies are explained below:
1. Legal Monopoly: If monopoly arises on account of legal support or as a matter of legal privilege, it is
called Legal Monopoly. Ex. Patent rights, special brands, trade means, copyright etc.
2. Voluntary Monopoly: To get the advantages of monopoly some private firms come together voluntarily
to control the supply of a commodity. These are called voluntary monopolies. Generally, these
monopolies arise with industrial combinations. These voluntary monopolies are of three kinds (a) cartel
(b) trust (c) holding company. It may be called artificial monopoly.
3. Government Monopoly: Sometimes the government will take the responsibility of supplying a
commodity and avoid private interference. Ex. Water, electricity. These monopolies, created to satisfy
social wants, are formed on social considerations. These are also called Social Monopolies.
4. Private Monopoly: If the total supply of a good is produced by a single private person or firm, it is called
private monopoly. Hindustan Lever Ltd. Is having the monopoly power to produce Lux Soap.
5. Limited Monopoly: if the monopolist is having limited power in fixing the price of his product, it is
called as ‘Limited Monopoly’. It may be due to the fear of distant substitutes or government intervention
or the entry of rivals firms.
6. Unlimited Monopoly: If the monopolist is having unlimited power in fixing the price of his good or
service, it is called unlimited monopoly. Ex. A doctor in a village.
7. Single Price Monopoly: When the monopolist charges same price for all units of his product, it is called
single price monopoly. Ex. Tata Company charges the same price to all the Tata Indiaca Cars of the same
model.
8. Discriminating Monopoly: When a Monopolist charges different prices to different consumers for the
same product, it is called discriminating monopoly. A doctor may take Rs.20 from a rich man and only
Rs.2 from a poor man for the same treatment.
9. Natural Monopoly: Sometimes monopoly may arise due to scarcity of natural resources. Nature
provides raw materials only in some places. The owner of the place will become monopolist. For Ex.
Diamond mine in South Africa.
Pricing under Monopoly
Monopoly refers to a market situation where there is only one seller. He has complete control over the supply of a
commodity. He is therefore in a position to fix any price. Under monopoly there is no distinction between a firm
and an industry. This is because the entire industry consists of a single firm.
Being the sole producer, the monopolist has complete control over the supply of the commodity. He has also the
power to influence the market price. He can raise the price by reducing his output and lower the price by
increasing his output. Thus he is a price-maker. He can fix the price to his maximum advantages. But he cannot
fix both the supply and the price, simultaneously. He can do one thing at a time. If the fixes the price, his output
will be determined by the market demand for his commodity. On the other hand, if he fixes the output to be sold,
its market will determine the price for the commodity. Thus his decision to fix either the price or the output is
determined by the market demand.
The market demand curve of the monopolist (the average revenue curve) is downward sloping. Its corresponding
marginal revenue curve is also downward sloping. But the marginal revenue curve lies below the average revenue
curve as shown in the figure. The monopolist faces the down-sloping demand curve because to sell more output,
he must reduce the price of his product. The firm’s demand curve and industry’s demand curve are one and the
same. The average cost and marginal cost curve are U shaped curve. Marginal cost falls and rises steeply when
compared to average cost.
Price output determination (Equilibrium Point)
The monopolistic firm attains equilibrium when its marginal cost becomes equal to the marginal revenue. The
monopolist always desires to make maximum profits. He makes maximum profits when MC=MR. He does not
increasing his output if his revenue exceeds his costs. But when the costs exceed the revenue, the monopolist firm
incur loses. Hence the monopolist curtails his production. He produces up to that point where additional cost is
equal to the additional revenue (MR=MC). Thus point is called equilibrium point. The price output determination
under monopoly may be explained with the help of a diagram.
In the diagram 6.12 the quantity supplied or demanded is shown along X-axis. The cost or revenue is shown along
Y-axis. AC and MC are the average cost and marginal cost curves respectively. AR and MR curves slope
downwards from left to right. AC and MC and U shaped curves. The monopolistic firm attains equilibrium when
its marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the MC curve may cut the MR curve
from below or from a side. In the diagram, the above condition is satisfied at point E. At point E, MC=MR. The
firm is in equilibrium. The equilibrium output is OM.
The above diagram (Average revenue) = MQ or OP

Average cost = MR
Profit per unit = Average Revenue-Average cost=MQ-MR=QR
Total Profit = QRXSR=PQRS
The area PQRS resents the maximum profit earned by the monopoly firm.
But it is not always possible for a monopolist to earn super-normal profits. If the demand and cost situations are
not favorable, the monopolist may realize short run losses.
Through the monopolist is a price marker, due to weak demand and high costs; he suffers a loss equal to PABC.
If AR > AC -> Abnormal or super normal profits.

If AR = AC -> Normal Profit
If AR < AC -> Loss
In the long run the firm has time to adjust his plant size or to use existing plant so as to maximize profits.
Monopolistic competition
Perfect competition and pure monopoly are rate phenomena in the real world. Instead, almost every market seems
to exhibit characteristics of both perfect competition and monopoly. Hence in the real world it is the state of
imperfect competition lying between these two extreme limits that work. Edward. H. Chamberlain developed the
theory of monopolistic competition, which presents a more realistic picture of the actual market structure and the
nature of competition.
Characteristics of Monopolistic Competition
The important characteristics of monopolistic competition are:
1. Existence of Many firms: Industry consists of a large number of sellers, each one of whom does not feel
dependent upon others. Every firm acts independently without bothering about the reactions of its rivals.
The size is so large that an individual firm has only a relatively small part in the total market, so that each
firm has very limited control over the price of the product. As the number is relatively large it is difficult
for these firms to determine its price- output policies without considering the possible reactions of the
rival forms. A monopolistically competitive firm follows an independent price policy.
2. Product Differentiation: Product differentiation means that products are different in some ways, but not
altogether so. The products are not identical but the same time they will not be entirely different from
each other. IT really means that there are various monopolist firms competing with each other. An
example of monopolistic competition and product differentiation is the toothpaste produced by various
firms. The product of each firm is different from that of its rivals in one or more respects. Different
toothpastes like Colgate, Close-up, Forehans, Cibaca, etc., provide an example of monopolistic
competition. These products are relatively close substitute for each other but not perfect substitutes.
Consumers have definite preferences for the particular verities or brands of products offered for sale by
various sellers. Advertisement, packing, trademarks, brand names etc. help differentiation of products
even if they are physically identical.
3. Large Number of Buyers: There are large number buyers in the market. But the buyers have their own
brand preferences. So the sellers are able to exercise a certain degree of monopoly over them. Each seller
has to plan various incentive schemes to retain the customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic competition too, there
is freedom of entry and exit. That is, there is no barrier as found under monopoly.
5. Selling costs: Since the products are close substitute much effort is needed to retain the existing
consumers and to create new demand. So each firm has to spend a lot on selling cost, which includes cost
on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic competition. If the
buyers are fully aware of the quality of the product they cannot be influenced much by advertisement or
other sales promotion techniques. But in the business world we can see that thought the quality of certain
products is the same, effective advertisement and sales promotion techniques make certain brands
monopolistic. For examples, effective dealer service backed by advertisement-helped popularization of

some brands through the quality of almost all the cement available in the market remains the same.
7. The Group: Under perfect competition the term industry refers to all collection of firms producing a
homogenous product. But under monopolistic competition the products of various firms are not identical
through they are close substitutes. Prof. Chamberlin called the collection of firms producing close
substitute products as a group.
Price – Output Determination under Monopolistic Competition
Since under monopolistic competition different firms produce different varieties of products, different prices for
them will be determined in the market depending upon the demand and cost conditions. Each firm will set the
price and output of its own product. Here also the profit will be maximized when marginal revenue is equal to
marginal cost.
Short-run equilibrium of the firm:
In the short-run the firm is in equilibrium when marginal Revenue = Marginal Cost. In Fig 6.15 AR is the average
revenue curve. NMR marginal revenue curve, SMC short-run marginal cost curve, SAC short-run average cost
curve, MR and SMC interest at point E where output in OM and price MQ (i.e. OP). Thus the equilibrium output
or the maximum profit output is OM and the price MQ or OP. When the price (average revenue) is above average
cost a firm will be making supernormal profit. From the figure it can be seen that AR is above AC in the
equilibrium point. As AR is above AC, this firm is making abnormal profits in the short-run. The abnormal profit
per unit is QR, i.e., the difference between AR and AC at equilibrium point and the total supernormal profit is OR
X OM. This total abnormal profits is represented by the rectangle PQRS. As the demand curve here is highly
elastic, the excess price over marginal cost is rather low. But in monopoly the demand curve is inelastic. So the
gap between price and marginal cost will be rather large.
If the demand and cost conditions are less favorable the monopolistically competitive firm may incur loss in the
short-run fig 6.16 Illustrates this. A firm incurs loss when the price is less than the average cost of production. MQ
is the average cost and OS (i.e. MR) is the price per unit at equilibrium output OM. QR is the loss per unit. The
total loss at an output OM is OR X OM. The rectangle PQRS represents the total loses in the short run.
Long – Run Equilibrium of the Firm:
A monopolistically competitive firm will be long – run equilibrium at the output level where marginal cost equal
to marginal revenue. Monopolistically competitive firm in the long run attains equilibrium where MC=MR and
AC=AR Fig 6.17 shows this trend.
Oligopoly
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to sell.
Oligopoly is the form of imperfect competition where there are a few firms in the market, producing either a
homogeneous product or producing products, which are close but not perfect substitute of each other.
Characteristics of Oligopoly
The main features of oligopoly are:
1. Few Firms: There are only a few firms in the industry. Each firm contributes a sizeable share of the total
market. Any decision taken by one firm influence the actions of other firms in the industry. The various
firms in the industry compete with each other.
2. Interdependence: As there are only very few firms, any steps taken by one firm to increase sales, by
reducing price or by changing product design or by increasing advertisement expenditure will naturally
affect the sales of other firms in the industry. An immediate retaliatory action can be anticipated from the
other firms in the industry every time when one firm takes such a decision. He has to take this into
account when he takes decisions. So the decisions of all the firms in the industry are interdependent.
3. Indeterminate Demand Curve: The interdependence of the firms makes their demand curve
indeterminate. When one firm reduces price other firms also will make a cut in their prices. So he firm
cannot be certain about the demand for its product. Thus the demand curve facing an oligopolistic firm
loses its definiteness and thus is indeterminate as it constantly changes due to the reactions of the rival
firms.
4. Advertising and selling costs: Advertising plays a greater role in the oligopoly market when compared
to other market systems. According to Prof. William J. Banumol “it is only oligopoly that advertising
comes fully into its own”. A huge expenditure on advertising and sales promotion techniques is needed
both to retain the present market share and to increase it. So Banumol concludes “under oligopoly,
advertising can become a life-and-death matter where a firm which fails to keep up with the advertising
budget of its competitors may find its customers drifting off to rival products.”
5. Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced price it is with the
intention of attracting the customers of other firms in the industry. In order to retain their consumers they
will also reduce price. Thus the pricing decision of one firm results in a loss to all the firms in the
industry. If one firm increases price. Other firms will remain silent there by allowing that firm to lost its
customers. Hence, no firm will be ready to change the prevailing price. It causes price rigidity in the
oligopoly market.
OTHER MARKET STRUCTURES
Duopoly
Duopoly refers to a market situation in which there are only two sellers. As there are only two sellers any decision
taken by one seller will have reaction from the other Eg. Coca-Cola and Pepsi. Usually these two sellers may
agree to co-operate each other and share the market equally between them, So that they can avoid harmful
competition.
The duopoly price, in the long run, may be a monopoly price or competitive price, or it may settle at any level
between the monopoly price and competitive price. In the short period, duopoly price may even fall below the
level competitive price with the both the firms earning less than even the normal price.
Monopsony
Mrs. Joan Robinson was the first writer to use the term monopsony to refer to market, which there is a single
buyer. Monoposony is a single buyer or a purchasing agency, which buys the show, or nearly whole of a
commodity or service produced. It may be created when all consumers of a commodity are organized together
and/or when only one consumer requires that commodity which no one else requires.
Bilateral Monopoly
A bilateral monopoly is a market situation in which a single seller (Monopoly) faces a single buyer
(Monoposony). It is a market of monopoly-monoposy.
Oligopsony
Oligopsony is a market situation in which there will be a few buyers and many sellers. As the sellers are more and
buyers are few, the price of product will be comparatively low but not as low as under monopoly.
PRICING METHODS
The micro – economic principle of profit maximization suggests pricing by the marginal analysis. That is by
equating MR to MC. However the pricing methods followed by the firms in practice around the world rarely
follow this procedure. This is for two reasons; uncertainty with regard to demand and cost function and the
deviation from the objective of short run profit maximization.
It was seen that there is no unique theory of firm behavior. While profit certainly on important variable for which
every firm cares. Maximization of short – run profit is not a popular objective of a firm today. At the most firms
seek maximum profit in the long run. If so the problem is dynamic and its solution requires accurate knowledge of
demand and cost conditions over time. Which is impossible to come by?
In view of these problems economic prices are a rare phenomenon. Instead, firms set prices for their products
through several alternative means. The important pricing methods followed in practice are shown in the chart.
Cost Based Pricing
There are three versions of the cost – based pricing. Full – cost or break even pricing, cost plus pricing and the
marginal cost pricing. Under the first version, price just equals the average (total) cost. In the second version,
some mark-up is added to the average cost in arriving at the price. In the last version, price is set equal to the
marginal cost. While all these methods appear to be easy and straight forward, they are in fact associated with a
number of difficulties. Even through difficulties are there, the cost- oriented pricing is quite popular today.
The cost – based pricing has several strengths as well as limitations. The advantages are its simplicity,
acceptability and consistency with the target rate of return on investment and the price stability in general. The
limitations are difficulties in getting accurate estimates of cost (particularly of the future cost rather than the
historic cost) Volatile nature of the variable cost and its ignoring of the demand side of the market etc.
Competition based pricing
Some commodities are priced according to the competition in their markets. Thus we have the going rate method
of price and the sealed bid pricing technique. Under the former a firm prices its new product according to the
prevailing prices of comparable products in the market. If the product is new in the country, then its import cost –
inclusive of the costs of certificates, insurance, and freight and customs duty, is used as the basis for pricing,
Incidentally, the price is not necessarily equal to the import cost, but to the firm is either new in the country, or is
a close substitute or complimentary to some other products, the prices of hitherto existing bands or / and of the
related goods are taken in to a account while deciding its price. Thus, when television was first manufactures in
India, its import cost must have been a guiding force in its price determination. Similarly, when
maruti car was first manufactured in India, it must have taken into account the prices of existing cars, price of
petrol, price of car accessories, etc. Needless to say, the going rate price could be below or above the average cost
and it could even be an economic price.
The sealed bid pricing method is quite popular in the case of construction activities and in the disposition of used
produces. In this method the prospective seller (buyers) are asked to quote their prices through a sealed cover, all
the offers are opened at a preannounce time in the presence of all the competitors, and the one who quoted the
least is awarded the contract (purchase / sale deed). As it sound, this method is totally competition based and if the
competitors unit by any change, the buyers (seller) may have to pay (receive) an exorbitantly high (too low) price,
thus there is a great degree of risk attached to this method of pricing.
Demand Based Pricing
The demand – based pricing and strategy – based pricing are quite related. The seller knows rather well that the
demand for its product is a decreasing function of the price its sets for product. Thus if seller wishes to sell more
he must reduce the price of his product, and if he wants a good price for his product, he could sell only a limited
quantity of his good. Demand oriented pricing rules imply establishment of prices in accordance with consumer
preference and perceptions and the intensity of demand.
Two general types demand oriented pricing rules can be identified.
i. Perceived value pricing and

ii. Differential pricing
Perceived value pricing considers the buyer’s perception of the value of the product ad the basis of pricing. Here
the pricing rule is that the firm must develop procedures for measuring the relative value of the product as
perceived by consumers. Differential pricing is nothing but price discrimination. In involves selling a product or
service for different prices in different market segments. Price differentiation depends on geographical location of
the consumers, type of consumer, purchasing quantity, season, time of the service etc. E.g. Telephone charges,
APSRTC charges.
Strategy based pricing (new product pricing)
A firm which products a new product, if it is also new to industry, can earn very good profits it if handles
marketing carefully, because of the uniqueness of the product. The price fixed for the new product must keep the
competitors away. Earn good profits for the firm over the life of the product and must help to get the product
accepted. The company can select either skimming pricing or penetration pricing.
While there are some firms, which follow the strategy of price penetration, there are some others who opt for price
– skimming. Under the former, firms sell their new product at a low price in the beginning in order to catch the
attention of consumers, once the product image and credibility is established, the seller slowly starts jacking up
the price to reap good profits in future. Under this strategy, a firm might well sell its product below the cost of
production and thus runs into losses to start with but eventually it recovers all its losses and even makes good
overall profits. The Rin washing soap perhaps falls into this category. This soap was sold at a rather low price in
the beginning and the firm even distributed free samples. Today, it is quite an expensive brand and yet it is selling
very well. Under the price – skimming strategy, the new product is priced high in the beginning, and its price is
reduced gradually as it faces a dearth of buyers such a strategy may be beneficial for products, which are fancy,
but of poor quality and / or of insignificant use over a period of time.
A prudent producer follows a good mix of the various pricing methods rather than adapting any once of them.
This is because no method is perfect and every method has certain good features further a firm might adopt one
method at one time and another method at some other accession.
BUSINESS AND NEW ECONOMIC ENVIRONMENT
Imagine you want to do business. Which are you interested in? For example, you want to get into InfoTech
industry. What can you do in this industry? Which one do you choose? The following are the alternatives you
have on hand:
 You can bye and sell

 You can set up a small/medium/large industry to manufacture
 You can set up a workshop to repair
 You can develop software
 You can design hardware
 You can be a consultant/trouble-shooter
If you choose any one or more of the above, you have chosen the line of activity. The next step for you is to
decide whether.
 You want to be only owner (It means you what to be sole trader) or
 You want to take some more professionals as co-owners along with you (If means you what to from
partnership with others as partners) or
 You want to be a global player by mobilizing large resources across the country/world
 You want to bring all like-minded people to share the benefits of the common enterprise (You want to
promote a joint stock company) or
 You want to involve government in the IT business (here you want to suggest government to promote a
public enterprise!)
To decide this, it is necessary to know how to evaluate each of these alternatives.
Factors affecting the choice of form of business organization
Before we choose a particular form of business organization, let us study what factors affect such a choice? The
following are the factors affecting the choice of a business organization:
1. Easy to start and easy to close: The form of business organization should be such that it should be easy
to close. There should not be hassles or long procedures in the process of setting up business or closing
the same.
2. Division of labour: There should be possibility to divide the work among the available owners.
3. Large amount of resources: Large volume of business requires large volume of resources. Some forms
of business organization do not permit to raise larger resources. Select the one which permits to mobilize
the large resources.
4. Liability: The liability of the owners should be limited to the extent of money invested in business. It is
better if their personal properties are not brought into business to make up the losses of the business.
5. Secrecy: The form of business organization you select should be such that it should permit to take care of
the business secrets. We know that century old business units are still surviving only because they could
successfully guard their business secrets.
6. Transfer of ownership: There should be simple procedures to transfer the ownership to the next legal
heir.
7. Ownership, Management and control: If ownership, management and control are in the hands of one or
a small group of persons, communication will be effective and coordination will be easier. Where
ownership, management and control are widely distributed, it calls for a high degree of professional’s
skills to monitor the performance of the business.
8. Continuity: The business should continue forever and ever irrespective of the uncertainties in future.
9. Quick decision-making: Select such a form of business organization, which permits you to take
decisions quickly and promptly. Delay in decisions may invalidate the relevance of the decisions.
10. Personal contact with customer: Most of the times, customers give us clues to improve business. So
choose such a form, which keeps you close to the customers.
11. Flexibility: In times of rough weather, there should be enough flexibility to shift from one business to the
other. The lesser the funds committed in a particular business, the better it is.
12. Taxation: More profit means more tax. Choose such a form, which permits to pay low tax.
These are the parameters against which we can evaluate each of the available forms of business organizations.
SOLE TRADER
The sole trader is the simplest, oldest and natural form of business organization. It is also called sole
proprietorship. ‘Sole’ means one. ‘Sole trader’ implies that there is only one trader who is the owner of the
business.
It is a one-man form of organization wherein the trader assumes all the risk of ownership carrying out the business
with his own capital, skill and intelligence. He is the boss for himself. He has total operational freedom. He is the
owner, Manager and controller. He has total freedom and flexibility. Full control lies with him. He can take his
own decisions. He can choose or drop a particular product or business based on its merits. He need not discuss this
with anybody. He is responsible for himself. This form of organization is popular all over the world. Restaurants,
Supermarkets, pan shops, medical shops, hosiery shops etc.
Features
 It is easy to start a business under this form and also easy to close.
 He introduces his own capital. Sometimes, he may borrow, if necessary
 He enjoys all the profits and in case of loss, he lone suffers.
 He has unlimited liability which implies that his liability extends to his personal properties in case of loss.
 He has a high degree of flexibility to shift from one business to the other.
 Business secretes can be guarded well
 There is no continuity. The business comes to a close with the death, illness or insanity of the sole trader.
Unless, the legal heirs show interest to continue the business, the business cannot be restored.
 He has total operational freedom. He is the owner, manager and controller.

 He can be directly in touch with the customers.
 He can take decisions very fast and implement them promptly.
 Rates of tax, for example, income tax and so on are comparatively very low.
Advantages
The following are the advantages of the sole trader from of business organization:
1. Easy to start and easy to close: Formation of a sole trader from of organization is relatively easy even
closing the business is easy.
2. Personal contact with customers directly: Based on the tastes and preferences of the customers the
stocks can be maintained.
3. Prompt decision-making: To improve the quality of services to the customers, he can take any decision
and implement the same promptly. He is the boss and he is responsible for his business Decisions relating
to growth or expansion can be made promptly.
4. High degree of flexibility: Based on the profitability, the trader can decide to continue or change the
business, if need be.
5. Secrecy: Business secrets can well be maintained because there is only one trader.
6. Low rate of taxation: The rate of income tax for sole traders is relatively very low.
7. Direct motivation: If there are profits, all the profits belong to the trader himself. In other words. If he
works more hard, he will get more profits. This is the direct motivating factor. At the same time, if he
does not take active interest, he may stand to lose badly also.
8. Total Control: The ownership, management and control are in the hands of the sole trader and hence it is
easy to maintain the hold on business.
9. Minimum interference from government: Except in matters relating to public interest, government
does not interfere in the business matters of the sole trader. The sole trader is free to fix price for his
products/services if he enjoys monopoly market.
10. Transferability: The legal heirs of the sole trader may take the possession of the business.
Disadvantages
The following are the disadvantages of sole trader form:
1. Unlimited liability: The liability of the sole trader is unlimited. It means that the sole trader has to bring
his personal property to clear off the loans of his business. From the legal point of view, he is not
different from his business.
2. Limited amounts of capital: The resources a sole trader can mobilize cannot be very large and hence
this naturally sets a limit for the scale of operations.
3. No division of labour: All the work related to different functions such as marketing, production, finance,
labour and so on has to be taken care of by the sole trader himself. There is nobody else to take his
burden. Family members and relatives cannot show as much interest as the trader takes.
4. Uncertainty: There is no continuity in the duration of the business. On the death, insanity of insolvency
the business may be come to an end.
5. Inadequate for growth and expansion: This from is suitable for only small size, one-man-show type of
organizations. This may not really work out for growing and expanding organizations.
6. Lack of specialization: The services of specialists such as accountants, market researchers, consultants
and so on, are not within the reach of most of the sole traders.
7. More competition: Because it is easy to set up a small business, there is a high degree of competition
among the small businessmen and a few who are good in taking care of customer requirements along can
service.
8. Low bargaining power: The sole trader is the in the receiving end in terms of loans or supply of raw
materials. He may have to compromise many times regarding the terms and conditions of purchase of
materials or borrowing loans from the finance houses or banks.
PARTNERSHIP
Partnership is an improved from of sole trader in certain respects. Where there are like-minded persons with
resources, they can come together to do the business and share the profits/losses of the business in an agreed ratio.
Persons who have entered into such an agreement are individually called ‘partners’ and collectively called ‘firm’.
The relationship among partners is called a partnership.
Indian Partnership Act, 1932 defines partnership as the relationship between two or more persons who agree to
share the profits of the business carried on by all or any one of them acting for all.
Features
1. Relationship: Partnership is a relationship among persons. It is relationship resulting out of an

agreement.
2. Two or more persons: There should be two or more number of persons.
3. There should be a business: Business should be conducted.
4. Agreement: Persons should agree to share the profits/losses of the business
5. Carried on by all or any one of them acting for all: The business can be carried on by all or any one of
the persons acting for all. This means that the business can be carried on by one person who is the agent
for all other persons. Every partner is both an agent and a principal. Agent for other partners and principal
for himself. All the partners are agents and the ‘partnership’ is their principal.
The following are the other features:
(a) Unlimited liability: The liability of the partners is unlimited. The partnership and partners, in the eye of
law, and not different but one and the same. Hence, the partners have to bring their personal assets to
clear the losses of the firm, if any.
(b) Number of partners: According to the Indian Partnership Act, the minimum number of partners should
be two and the maximum number if restricted, as given below:
 10 partners is case of banking business
 20 in case of non-banking business

(c) Division of labour: Because there are more than two persons, the work can be divided among the
partners based on their aptitude.
(d) Personal contact with customers: The partners can continuously be in touch with the customers to
monitor their requirements.
(e) Flexibility: All the partners are likeminded persons and hence they can take any decision relating to
business.
Partnership Deed
The written agreement among the partners is called ‘the partnership deed’. It contains the terms and conditions
governing the working of partnership. The following are contents of the partnership deed.
1. Names and addresses of the firm and partners

2. Nature of the business proposed
3. Duration
4. Amount of capital of the partnership and the ratio for contribution by each of the partners.
5. Their profit sharing ration (this is used for sharing losses also)
6. Rate of interest charged on capital contributed, loans taken from the partnership and the amounts drawn,
if any, by the partners from their respective capital balances.
7. The amount of salary or commission payable to any partner
8. Procedure to value good will of the firm at the time of admission of a new partner, retirement of death of
a partner
9. Allocation of responsibilities of the partners in the firm
10. Procedure for dissolution of the firm
11. Name of the arbitrator to whom the disputes, if any, can be referred to for settlement.
12. Special rights, obligations and liabilities of partners(s), if any.
KIND OF PARTNERS
The following are the different kinds of partners:
1. Active Partner: Active partner takes active part in the affairs of the partnership. He is also called
working partner.
2. Sleeping Partner: Sleeping partner contributes to capital but does not take part in the affairs of the
partnership.
3. Nominal Partner: Nominal partner is partner just for namesake. He neither contributes to capital nor
takes part in the affairs of business. Normally, the nominal partners are those who have good business
connections, and are well places in the society.
4. Partner by Estoppels: Estoppels means behavior or conduct. Partner by estoppels gives an impression to
outsiders that he is the partner in the firm. In fact be neither contributes to capital, nor takes any role in
the affairs of the partnership.
5. Partner by holding out: If partners declare a particular person (having social status) as partner and this
person does not contradict even after he comes to know such declaration, he is called a partner by holding
out and he is liable for the claims of third parties. However, the third parties should prove they entered
into contract with the firm in the belief that he is the partner of the firm. Such a person is called partner by
holding out.
6. Minor Partner: Minor has a special status in the partnership. A minor can be admitted for the benefits of
the firm. A minor is entitled to his share of profits of the firm. The liability of a minor partner is limited to
the extent of his contribution of the capital of the firm.
Right of partners
Every partner has right
(a) To take part in the management of business

(b) To express his opinion
(c) Of access to and inspect and copy and book of accounts of the firm
(d) To share equally the profits of the firm in the absence of any specific agreement to the contrary
(e) To receive interest on capital at an agreed rate of interest from the profits of the firm
(f) To receive interest on loans, if any, extended to the firm.
(g) To be indemnified for any loss incurred by him in the conduct of the business
(h) To receive any money spent by him in the ordinary and proper conduct of the business of the firm.
Advantages
The following are the advantages of the partnership from:
1. Easy to form: Once there is a group of like-minded persons and good business proposal, it is easy to start
and register a partnership.
2. Availability of larger amount of capital: More amount of capital can be raised from more number of
partners.
3. Division of labour: The different partners come with varied backgrounds and skills. This facilities
division of labour.
4. Flexibility: The partners are free to change their decisions, add or drop a particular product or start a new
business or close the present one and so on.
5. Personal contact with customers: There is scope to keep close monitoring with customers requirements
by keeping one of the partners in charge of sales and marketing. Necessary changes can be initiated based
on the merits of the proposals from the customers.
6. Quick decisions and prompt action: If there is consensus among partners, it is enough to implement any
decision and initiate prompt action. Sometimes, it may more time for the partners on strategic issues to
reach consensus.
7. The positive impact of unlimited liability: Every partner is always alert about his impending danger of
unlimited liability. Hence he tries to do his best to bring profits for the partnership firm by making good
use of all his contacts.
Disadvantages:
The following are the disadvantages of partnership:
1. Formation of partnership is difficult: Only like-minded persons can start a partnership. It is

sarcastically said,’ it is easy to find a life partner, but not a business partner’.
2. Liability: The partners have joint and several liabilities beside unlimited liability. Joint and several
liability puts additional burden on the partners, which means that even the personal properties of the
partner or partners can be attached. Even when all but one partner become insolvent, the solvent partner
has to bear the entire burden of business loss.
3. Lack of harmony or cohesiveness: It is likely that partners may not, most often work as a group with
cohesiveness. This result in mutual conflicts, an attitude of suspicion and crisis of confidence. Lack of
harmony results in delay in decisions and paralyses the entire operations.
4. Limited growth: The resources when compared to sole trader, a partnership may raise little more. But
when compare to the other forms such as a company, resources raised in this form of organization are
limited. Added to this, there is a restriction on the maximum number of partners.
5. Instability: The partnership form is known for its instability. The firm may be dissolved on death,
insolvency or insanity of any of the partners.
6. Lack of Public confidence: Public and even the financial institutions look at the unregistered firm with a
suspicious eye. Though registration of the firm under the Indian Partnership Act is a solution of such
problem, this cannot revive public confidence into this form of organization overnight. The partnership
can create confidence in other only with their performance.
JOINT STOCK COMPANY
The joint stock company emerges from the limitations of partnership such as joint and several liability, unlimited
liability, limited resources and uncertain duration and so on. Normally, to take part in a business, it may need
large money and we cannot foretell the fate of business. It is not literally possible to get into business with little
money. Against this background, it is interesting to study the functioning of a joint stock company. The main
principle of the joint stock company from is to provide opportunity to take part in business with a low investment
as possible say Rs.1000. Joint Stock Company has been a boon for investors with moderate funds to invest.
The word ‘ company’ has a Latin origin, com means ‘ come together’, pany means ‘ bread’, joint stock company
means, people come together to earn their livelihood by investing in the stock of company jointly.
Company Defined
Lord justice Lindley explained the concept of the joint stock company from of organization as ‘an association of
many persons who contribute money or money’s worth to a common stock and employ it for a common purpose.
Features
This definition brings out the following features of the company:
1. Artificial person: The Company has no form or shape. It is an artificial person created by law. It is
intangible, invisible and existing only, in the eyes of law.
2. Separate legal existence: it has an independence existence, it separate from its members. It can acquire
the assets. It can borrow for the company. It can sue other if they are in default in payment of dues,
breach of contract with it, if any. Similarly, outsiders for any claim can sue it. A shareholder is not liable
for the acts of the company. Similarly, the shareholders cannot bind the company by their acts.
3. Voluntary association of persons: The Company is an association of voluntary association of persons
who want to carry on business for profit. To carry on business, they need capital. So they invest in the
share capital of the company.
4. Limited Liability: The shareholders have limited liability i.e., liability limited to the face value of the
shares held by him. In other words, the liability of a shareholder is restricted to the extent of his
contribution to the share capital of the company. The shareholder need not pay anything, even in times of
loss for the company, other than his contribution to the share capital.
5. Capital is divided into shares: The total capital is divided into a certain number of units. Each unit is
called a share. The price of each share is priced so low that every investor would like to invest in the
company. The companies promoted by promoters of good standing (i.e., known for their reputation in
terms of reliability character and dynamism) are likely to attract huge resources.
6. Transferability of shares: In the company form of organization, the shares can be transferred from one
person to the other. A shareholder of a public company can cell sell his holding of shares at his will.
However, the shares of a private company cannot be transferred. A private company restricts the
transferability of the shares.
7. Common Seal: As the company is an artificial person created by law has no physical form, it cannot sign
its name on a paper; so, it has a common seal on which its name is engraved. The common seal should
affix every document or contract; otherwise the company is not bound by such a document or contract.
8. Perpetual succession: ‘Members may comes and members may go, but the company continues for ever
and ever’ A. company has uninterrupted existence because of the right given to the shareholders to
transfer the shares.
9. Ownership and Management separated: The shareholders are spread over the length and breadth of the
country, and sometimes, they are from different parts of the world. To facilitate administration, the
shareholders elect some among themselves or the promoters of the company as directors to a Board,
which looks after the management of the business. The Board recruits the managers and employees at
different levels in the management. Thus the management is separated from the owners.
10. Winding up: Winding up refers to the putting an end to the company. Because law creates it, only law
can put an end to it in special circumstances such as representation from creditors of financial institutions,
or shareholders against the company that their interests are not safeguarded. The company is not affected
by the death or insolvency of any of its members.
11. The name of the company ends with ‘limited’: it is necessary that the name of the company ends with
limited (Ltd.) to give an indication to the outsiders that they are dealing with the company with limited
liability and they should be careful about the liability aspect of their transactions with the company.
Formation of Joint Stock company
There are two stages in the formation of a joint stock company. They are:
(a) To obtain Certificates of Incorporation

(b) To obtain certificate of commencement of Business
Certificate of Incorporation: The certificate of Incorporation is just like a ‘date of birth’ certificate. It certifies that
a company with such and such a name is born on a particular day.
Certificate of commencement of Business: A private company need not obtain the certificate of commencement of
business. It can start its commercial operations immediately after obtaining the certificate of Incorporation.
The persons who conceive the idea of starting a company and who organize the necessary initial resources are
called promoters. The vision of the promoters forms the backbone for the company in the future to reckon with.
The promoters have to file the following documents, along with necessary fee, with a registrar of joint stock
companies to obtain certificate of incorporation:
(a) Memorandum of Association: The Memorandum of Association is also called the charter of the
company. It outlines the relations of the company with the outsiders. If furnishes all its details in six
clause such as (ii) Name clause (II) situation clause (iii) objects clause (iv) Capital clause and (vi)
subscription clause duly executed by its subscribers.
(b) Articles of association: Articles of Association furnishes the byelaws or internal rules government the
internal conduct of the company.
(c) The list of names and address of the proposed directors and their willingness, in writing to act as such, in
case of registration of a public company.
(d) A statutory declaration that all the legal requirements have been fulfilled. The declaration has to be duly
signed by any one of the following: Company secretary in whole practice, the proposed director, legal
solicitor, chartered accountant in whole time practice or advocate of High court.
The registrar of joint stock companies peruses and verifies whether all these documents are in order or not. If he is
satisfied with the information furnished, he will register the documents and then issue a certificate of
incorporation, if it is private company, it can start its business operation immediately after obtaining certificate of
incorporation.
Advantages
The following are the advantages of a joint Stock Company
1. Mobilization of larger resources: A joint stock company provides opportunity for the investors to
invest, even small sums, in the capital of large companies. The facilities rising of larger resources.
2. Separate legal entity: The Company has separate legal entity. It is registered under Indian Companies
Act, 1956.
3. Limited liability: The shareholder has limited liability in respect of the shares held by him. In no case,
does his liability exceed more than the face value of the shares allotted to him.
4. Transferability of shares: The shares can be transferred to others. However, the private company shares
cannot be transferred.
5. Liquidity of investments: By providing the transferability of shares, shares can be converted into cash.
6. Inculcates the habit of savings and investments: Because the share face value is very low, this
promotes the habit of saving among the common man and mobilizes the same towards investments in the
company.
7. Democracy in management: the shareholders elect the directors in a democratic way in the general body
meetings. The shareholders are free to make any proposals, question the practice of the management,
suggest the possible remedial measures, as they perceive, The directors respond to the issue raised by the
shareholders and have to justify their actions.
8. Economics of large scale production: Since the production is in the scale with large funds at
9. Continued existence: The Company has perpetual succession. It has no natural end. It continues forever
and ever unless law put an end to it.
10. Institutional confidence: Financial Institutions prefer to deal with companies in view of their
professionalism and financial strengths.
11. Professional management: With the larger funds at its disposal, the Board of Directors recruits
competent and professional managers to handle the affairs of the company in a professional manner.
12. Growth and Expansion: With large resources and professional management, the company can earn good
returns on its operations, build good amount of reserves and further consider the proposals for growth and
expansion.
All that shines is not gold. The company from of organization is not without any disadvantages. The following are
the disadvantages of joint stock companies.
Disadvantages
1. Formation of company is a long drawn procedure: Promoting a joint stock company involves a long
drawn procedure. It is expensive and involves large number of legal formalities.
2. High degree of government interference: The government brings out a number of rules and regulations
governing the internal conduct of the operations of a company such as meetings, voting, audit and so on,
and any violation of these rules results into statutory lapses, punishable under the companies act.
3. Inordinate delays in decision-making: As the size of the organization grows, the number of levels in
organization also increases in the name of specialization. The more the number of levels, the more is the
delay in decision-making. Sometimes, so-called professionals do not respond to the urgencies as required.
It promotes delay in administration, which is referred to ‘red tape and bureaucracy’.
4. Lack or initiative: In most of the cases, the employees of the company at different levels show slack in
their personal initiative with the result, the opportunities once missed do not recur and the company loses
the revenue.
5. Lack of responsibility and commitment: In some cases, the managers at different levels are afraid to
take risk and more worried about their jobs rather than the huge funds invested in the capital of the
company lose the revenue.
6. Lack of responsibility and commitment: In some cases, the managers at different levels are afraid to
take risk and more worried about their jobs rather than the huge funds invested in the capital of the
company. Where managers do not show up willingness to take responsibility, they cannot be considered
as committed. They will not be able to handle the business risks.
PUBLIC ENTERPRISES
Public enterprises occupy an important position in the Indian economy. Today, public enterprises provide the
substance and heart of the economy. Its investment of over Rs.10,000 crore is in heavy and basic industry, and
infrastructure like power, transport and communications. The concept of public enterprise in Indian dates back to
the era of pre-independence.
Genesis of Public Enterprises
In consequence to declaration of its goal as socialistic pattern of society in 1954, the Government of India realized
that it is through progressive extension of public enterprises only, the following aims of our five years plans can
be fulfilled.
 Higher production
 Greater employment
 Economic equality, and
 Dispersal of economic power
The government found it necessary to revise its industrial policy in 1956 to give it a socialistic bent.
Need for Public Enterprises
The Industrial Policy Resolution 1956 states the need for promoting public enterprises as follows:
 To accelerate the rate of economic growth by planned development

 To speed up industrialization, particularly development of heavy industries and to expand public sector
and to build up a large and growing cooperative sector.
 To increase infrastructure facilities
 To disperse the industries over different geographical areas for balanced regional development
 To increase the opportunities of gainful employment

 To help in raising the standards of living
 To reducing disparities in income and wealth (By preventing private monopolies and curbing
concentration of economic power and vast industries in the hands of a small number of individuals)
Achievements of public Enterprises
The achievements of public enterprise are vast and varied. They are:
1. Setting up a number of public enterprises in basic and key industries

2. Generating considerably large employment opportunities in skilled, unskilled, supervisory and
managerial cadres.
3. Creating internal resources and contributing towards national exchequer for funds for development and
welfare.
4. Bringing about development activities in backward regions, through locations in different areas of the
country.
5. Assisting in the field of export promotion and conservation of foreign exchange.
6. Creating viable infrastructure and bringing about rapid industrialization (ancillary industries developed
around the public sector as its nucleus).
7. Restricting the growth of private monopolies
8. Stimulating diversified growth in private sector
9. Taking over sick industrial units and putting them, in most of the vases, in order,
10. Creating financial systems, through a powerful networking of financial institutions, development and
promotional institutions, which has resulted in social control and social orientation of investment, credit
and capital management systems.
11. Benefiting the rural areas, priority sectors, small business in the fields of industry, finance, credit,
services, trade, transport, consultancy and so on.
Let us see the different forms of public enterprise and their features now.
Forms of public enterprises
Public enterprises can be classified into three forms:
(a) Departmental undertaking

(b) Public corporation
(c) Government company
These are explained below
Departmental Undertaking
This is the earliest from of public enterprise. Under this form, the affairs of the public enterprise are carried out
under the overall control of one of the departments of the government. The government department appoints a
managing director (normally a civil servant) for the departmental undertaking. He will be given the executive
authority to take necessary decisions. The departmental undertaking does not have a budget of its own. As and
when it wants, it draws money from the government exchequer and when it has surplus money, it deposits it in the
government exchequer. However, it is subject to budget, accounting and audit controls.
Examples for departmental undertakings are Railways, Department of Posts, All India Radio, Doordarshan,
Defence undertakings like DRDL, DLRL, ordinance factories, and such.
Features
1. Under the control of a government department: The departmental undertaking is not an independent
organization. It has no separate existence. It is designed to work under close control of a government
department. It is subject to direct ministerial control.
2. More financial freedom: The departmental undertaking can draw funds from government account as per
the needs and deposit back when convenient.
3. Like any other government department: The departmental undertaking is almost similar to any other
government department
4. Budget, accounting and audit controls: The departmental undertaking has to follow guidelines (as
applicable to the other government departments) underlying the budget preparation, maintenance of
accounts, and getting the accounts audited internally and by external auditors.
5. More a government organization, less a business organization . The set up of a departmental undertaking
is more rigid, less flexible, slow in responding to market needs.
Advantages
1. Effective control: Control is likely to be effective because it is directly under the Ministry.
2. Responsible Executives: Normally the administration is entrusted to a senior civil servant. The
administration will be organized and effective.
3. Less scope for mystification of funds: Departmental undertaking does not draw any money more than is
needed, that too subject to ministerial sanction and other controls. So chances for mis-utilisation are low.
4. Adds to Government revenue: The revenue of the government is on the rise when the revenue of the
departmental undertaking is deposited in the government account.
Disadvantages
1. Decisions delayed: Control is centralized. This results in lower degree of flexibility. Officials in the lower
levels cannot take initiative. Decisions cannot be fast and actions cannot be prompt.
2. No incentive to maximize earnings: The departmental undertaking does not retain any surplus with it. So
there is no inventive for maximizing the efficiency or earnings.
3. Slow response to market conditions: Since there is no competition, there is no profit motive; there is no
incentive to move swiftly to market needs.
4. Redtapism and bureaucracy: The departmental undertakings are in the control of a civil servant and
under the immediate supervision of a government department. Administration gets delayed substantially.
5. Incidence of more taxes: At times, in case of losses, these are made up by the government funds only. To
make up these, there may be a need for fresh taxes, which is undesirable.
Any business organization to be more successful needs to be more dynamic, flexible, and responsive to market
conditions, fast in decision marking and prompt in actions. None of these qualities figure in the features of a
departmental undertaking. It is true that departmental undertaking operates as a extension to the government. With
the result, the government may miss certain business opportunities. So as not to miss business opportunities, the
government has thought of another form of public enterprise, that is, Public corporation.
PUBLIC CORPORATION
Having released that the routing government administration would not be able to cope up with the demand of its
business enterprises, the Government of India, in 1948, decided to organize some of its enterprises as statutory
corporations. In pursuance of this, Industrial Finance Corporation, Employees’ State Insurance Corporation was
set up in 1948.
Public corporation is a ‘right mix of public ownership, public accountability and business management for public
ends’. The public corporation provides machinery, which is flexible, while at the same time retaining public
control.
Definition
A public corporation is defined as a ‘body corporate create by an Act of Parliament or Legislature and notified by
the name in the official gazette of the central or state government. It is a corporate entity having perpetual
succession, and common seal with power to acquire, hold, dispose off property, sue and be sued by its name”.
Examples of a public corporation are Life Insurance Corporation of India, Unit Trust of India, Industrial Finance
Corporation of India, Damodar Valley Corporation and others.
Features
1. A body corporate: It has a separate legal existence. It is a separate company by itself. If can raise
resources, buy and sell properties, by name sue and be sued.
2. More freedom and day-to-day affairs: It is relatively free from any type of political interference. It
enjoys administrative autonomy.
3. Freedom regarding personnel: The employees of public corporation are not government civil servants.
The corporation has absolute freedom to formulate its own personnel policies and procedures, and these
are applicable to all the employees including directors.
4. Perpetual succession: A statute in parliament or state legislature creates it. It continues forever and till a
statue is passed to wind it up.
5. Financial autonomy: Through the public corporation is fully owned government organization, and the
initial finance are provided by the Government, it enjoys total financial autonomy, Its income and
expenditure are not shown in the annual budget of the government, it enjoys total financial autonomy. Its
income and expenditure are not shown in the annual budget of the government. However, for its freedom
it is restricted regarding capital expenditure beyond the laid down limits, and raising the capital through
capital market.
6. Commercial audit: Except in the case of banks and other financial institutions where chartered
accountants are auditors, in all corporations, the audit is entrusted to the comptroller and auditor general
of India.
7. Run on commercial principles: As far as the discharge of functions, the corporation shall act as far as
possible on sound business principles.
Advantages
1. Independence, initiative and flexibility: The corporation has an autonomous set up. So it is independent,
take necessary initiative to realize its goals, and it can be flexible in its decisions as required.
2. Scope for Redtapism and bureaucracy minimized : The Corporation has its own policies and procedures.
If necessary they can be simplified to eliminate redtapism and bureaucracy, if any.
3. Public interest protected: The corporation can protect the public interest by making its policies more
public friendly, Public interests are protected because every policy of the corporation is subject to
ministerial directives and board parliamentary control.
4. Employee friendly work environment: Corporation can design its own work culture and train its
employees accordingly. It can provide better amenities and better terms of service to the employees and
thereby secure greater productivity.
5. Competitive prices: the corporation is a government organization and hence can afford with minimum
margins of profit, It can offer its products and services at competitive prices.
6. Economics of scale: By increasing the size of its operations, it can achieve economics of large-scale
production.
7. Public accountability: It is accountable to the Parliament or legislature; it has to submit its annual report
on its working results.
Disadvantages
1. Continued political interference: the autonomy is on paper only and in reality, the continued.
2. Misuse of Power: In some cases, the greater autonomy leads to misuse of power. It takes time to unearth
the impact of such misuse on the resources of the corporation. Cases of misuse of power defeat the very
purpose of the public corporation.
3. Burden for the government: Where the public corporation ignores the commercial principles and suffers
losses, it is burdensome for the government to provide subsidies to make up the losses.
Government Company
Section 617 of the Indian Companies Act defines a government company as “any company in which not less than
51 percent of the paid up share capital” is held by the Central Government or by any State Government or
Governments or partly by Central Government and partly by one or more of the state Governments and includes
and company which is subsidiary of government company as thus defined”.
A government company is the right combination of operating flexibility of privately organized companies with the
advantages of state regulation and control in public interest.
Government companies differ in the degree of control and their motive also.
Some government companies are promoted as

 industrial undertakings (such as Hindustan Machine Tools, Indian Telephone Industries, and so on)
 Promotional agencies (such as National Industrial Development Corporation, National Small Industries
Corporation, and so on) to prepare feasibility reports for promoters who want to set up public or private
companies.
 Agency to promote trade or commerce. For example, state trading corporation, Export Credit Guarantee
Corporation and so such like.
 A company to take over the existing sick companies under private management (E.g. Hindustan
Shipyard)
 A company established as a totally state enterprise to safeguard national interests such as Hindustan
Aeronautics Ltd. And so on.
 Mixed ownership company in collaboration with a private consult to obtain technical know how and
guidance for the management of its enterprises, e.g. Hindustan Cables)
Features
The following are the features of a government company:

1. Like any other registered company: It is incorporated as a registered company under the Indian
companies Act. 1956. Like any other company, the government company has separate legal existence.
Common seal, perpetual succession, limited liability, and so on. The provisions of the Indian Companies
Act apply for all matters relating to formation, administration and winding up. However, the government
has a right to exempt the application of any provisions of the government companies.
2. Shareholding: The majority of the share are held by the Government, Central or State, partly by the
Central and State Government(s), in the name of the President of India, It is also common that the
collaborators and allotted some shares for providing the transfer of technology.
3. Directors are nominated: As the government is the owner of the entire or majority of the share capital of
the company, it has freedom to nominate the directors to the Board. Government may consider the
requirements of the company in terms of necessary specialization and appoints the directors accordingly.
4. Administrative autonomy and financial freedom: A government company functions independently with
full discretion and in the normal administration of affairs of the undertaking.
5. Subject to ministerial control: Concerned minister may act as the immediate boss. It is because it is the
government that nominates the directors, the minister issue directions for a company and he can call for
information related to the progress and affairs of the company any time.
Advantages
1. Formation is easy: There is no need for an Act in legislature or parliament to promote a government
company. A Government company can be promoted as per the provisions of the companies Act. Which is
relatively easier?
2. Separate legal entity: It retains the advantages of public corporation such as autonomy, legal entity.
3. Ability to compete: It is free from the rigid rules and regulations. It can smoothly function with all the
necessary initiative and drive necessary to complete with any other private organization. It retains its
independence in respect of large financial resources, recruitment of personnel, management of its affairs,
and so on.
4. Flexibility: A Government company is more flexible than a departmental undertaking or public
corporation. Necessary changes can be initiated, which the framework of the company law. Government
can, if necessary, change the provisions of the Companies Act. If found restricting the freedom of the
government company. The form of Government Company is so flexible that it can be used for taking over
sick units promoting strategic industries in the context of national security and interest.
5. Quick decision and prompt actions: In view of the autonomy, the government company take decision
quickly and ensure that the actions and initiated promptly.
6. Private participation facilitated: Government company is the only from providing scope for private
participation in the ownership. The facilities to take the best, necessary to conduct the affairs of business,
from the private sector and also from the public sector.
Disadvantages
1. Continued political and government interference: Government seldom leaves the government company
to function on its own. Government is the major shareholder and it dictates its decisions to the Board. The
Board of Directors gets these approved in the general body. There were a number of cases where the
operational polices were influenced by the whims and fancies of the civil servants and the ministers.
2. Higher degree of government control: The degree of government control is so high that the government
company is reduced to mere adjuncts to the ministry and is, in majority of the cases, not treated better
than the subordinate organization or offices of the government.
3. Evades constitutional responsibility: A government company is creating by executive action of the
government without the specific approval of the parliament or Legislature.
4. Poor sense of attachment or commitment: The members of the Board of Management of government
companies and from the ministerial departments in their ex-officio capacity. The lack the sense of
attachment and do not reflect any degree of commitment to lead the company in a competitive
environment.
5. Divided loyalties: The employees are mostly drawn from the regular government departments for a
defined period. After this period, they go back to their government departments and hence their divided
loyalty dilutes their interest towards their job in the government company.
6. Flexibility on paper: The powers of the directors are to be approved by the concerned Ministry,
particularly the power relating to borrowing, increase in the capital, appointment of top officials, entering
into contracts for large orders and restrictions on capital expenditure. The government companies are
rarely allowed to exercise their flexibility and independence.
UNIT- IV
CAPITAL AND CAPITAL BUDGETING

the Financial Management can be broken down in to three major decisions or functions of finance. They
are: (i) the investment decision, (ii) the financing decision and (iii) the dividend policy decision.
Investment Decision
The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets
as per their duration of benefits, can be categorized into two groups: (i) long-term assets which yield a return
over a period of time in future (ii) short-term or current assents which in the normal course of business are
convertible into cash usually with in a year. Accordingly, the asset selection decision of a firm is of two types.
The investment in long-term assets is popularly known as capital budgeting and in short-term assets, working
capital management.
1. Capital budgeting: Capital budgeting – the long – term investment decision – is probably the most
crucial financial decision of a firm. It relates to the selection of an assent or investment proposal or course
of action that benefits are likely to be available in future over the lifetime of the project.
The long-term investment may relate to acquisition of new asset or replacement of old assets. Whether an
asset will be accepted or not will depend upon the relative benefits and returns associated with it. The
measurement of the worth of the investment proposals is, therefore, a major element in the capital
budgeting exercise. The second element of the capital budgeting decision is the analysis of risk and
uncertainty as the benefits from the investment proposals pertain the future, which is uncertain. They
have to be estimated under various assumptions and thus there is an element of risk involved in the
exercise. The return from the capital budgeting decision should, therefore, be evaluated in relation to the
risk associated with it.
The third and final element is the ascertainment of a certain norm or standard against which the benefits
are to be judged. The norm is known by different names such as cut-off rate, hurdle rate, required rate,
minimum rate of return and so on. This standard is broadly expressed in terms of the cost of capital is,
thus, another major aspect of the capital; budgeting decision. In brief, the main elements of the capital
budgeting decision are: (i) The total assets and their composition (ii) The business risk complexion of the
firm, and (iii) concept and measurement of the cost of capital.
2. Working Capital Management: Working capital management is concerned with the management of the
current assets. As we know, the short-term survival is a pre-requisite to long-term success. The major
thrust of working capital management is the trade-off between profitability and risk (liquidity), which are
inversely related to each other. If a firm does not have adequate working capital it may not have the
ability to meet its current obligations and thus invite the risk of bankrupt. One the other hand if the
current assets are too large the firm will be loosing the opportunity of making a good return and thus may
not serve the requirements of suppliers of funds. Thus, the profitability and liquidity are the two major
dimensions of working capital management. In addition, the individual current assets should be
efficiently managed so that neither inadequate nor unnecessary funds are locked up.
Finance Decision
The second major decision involved in financial management is the financing decision, which is concerned
with the financing – mix or capital structure of leverage. The term capital structure refers to the combination
of debt (fixed interest sources of financing) and equity capital (variable – dividend securities/source of funds).
The financing decision of a firm relates to the choice of the proportion of these sources to finance the
investment requirements. A higher proportion of debt implies a higher return to the shareholders and also the
higher financial risk and vice versa. A proper balance between debt and equity is a must to ensure a trade –
off between risk and return to the shareholders. A capital structure with a reasonable proportion of debt and
equity capital is called the optimum capital structure.
The second aspect of the financing decision is the determination of an appropriate capital structure, which will
result, is maximum return to the shareholders and in turn maximizes the worth of the firm. Thus, the financing
decision covers two inter-related aspects: (a) capital structure theory, and (b) capital structure decision.
Dividend Policy decision
The third major decision of financial management is relating to dividend policy. The firm has two alternatives
with regard to management of profits of a firm. They can be either distributed to the shareholder in the form
of dividends or they can be retained in the business or even distribute some portion and retain the remaining.
The course of action to be followed is a significant element in the dividend decision. The dividend pay out
ratio i. e. the proportion of net profits to be paid out to the shareholders should be in tune with the investment
opportunities available within the firm. The second major aspect of the dividend decision is the study of
factors determining dividend policy of a firm in practice.
WORKING CAPITAL ANALYSIS
Finance is required for two purpose viz. for it establishment and to carry out the day-to-day operations of a
business. Funds are required to purchase the fixed assets such as plant, machinery, land, building, furniture, etc,
on long-term basis. Investments in these assets represent that part of firm’s capital, which is blocked on a
permanent of fixed basis and is called fixed capital. Funds are also needed for short-term purposes such as the
purchase of raw materials, payment of wages and other day-to-day expenses, etc. and these funds are known as
working capital. In simple words working capital refers that part of the firm’s capital, which is required for
financing short term or current assets such as cash, marketable securities, debtors and inventories. The investment
in these current assets keeps revolving and being constantly converted into cash and which in turn financed to
acquire current assets. Thus the working capital is also known as revolving or circulating capital or short-term
capital.
Concept of working capital
There are two concepts of working capital:
1. Gross working capital

2. Net working capital
Gross working capital:

In the broader sense, the term working capital refers to the gross working capital. The notion of the gross working
capital refers to the capital invested in total current assets of the enterprise. Current assets are those assets, which
in the ordinary course of business, can be converted into cash within a short period, normally one accounting year.
Examples of current assets:
1. Cash in hand and bank balance

2. Bills receivables or Accounts Receivables
3. Sundry Debtors (less provision for bad debts)
4. Short-term loans and advances.
5. Inventories of stocks, such as:
(a) Raw materials
(b) Work – in process
(c) Stores and spares
(d) Finished goods
6. Temporary Investments of surplus funds.
7. Prepaid Expenses
8. Accrued Incomes etc.
Net working capital:

In a narrow sense, the term working capital refers to the net working capital. Networking capital represents the
excess of current assets over current liabilities.
Current liabilities are those liabilities, which are intend to be paid in the ordinary course of business within a short
period, normally one accounting year out of the current assets or the income of the business. Net working capital
may be positive or negative. When the current assets exceed the current liabilities net working capital is positive
and the negative net working capital results when the liabilities are more then the current assets.
Examples of current liabilities:
1. Bills payable
2. Sundry Creditors or Accounts Payable.
3. Accrued or Outstanding Expanses.
4. Short term loans, advances and deposits.
5. Dividends payable
6. Bank overdraft
7. Provision for taxation etc.
Classification or kinds of working capital
Working capital may be classified in two ways:
a. On the basis of concept.

b. On the basis of time permanency
On the basis of concept, working capital is classified as gross working capital and net working capital is
discussed earlier. This classification is important from the point of view of the financial manager. On the basis
of time, working capital may be classified as:
1. Permanent or fixed working capital

2. Temporary of variable working capital
1. Permanent or fixed working capital: There is always a minimum level of current assets, which is
continuously required by the enterprise to carry out its normal business operations and this minimum is
known as permanent of fixed working capital. For example, every firm has to maintain a minimum level
of raw materials, work in process; finished goods and cash balance to run the business operations
smoothly and profitably. This minimum level of current assets is permanently blocked in current assets.
As the business grows, the requirement of permanent working capital also increases due to the increases
in current assets. The permanent working capital can further be classified into regular working capital and
reserve working capital. Regular working capital is the minimum amount of working capital required to
ensure circulation of current assets from cash to inventories, from inventories to receivables and from
receivable to cash and so on. Reserve working capital is the excess amount over the requirement for
regular working capital which may be provided for contingencies that may arise at unstated period such
as strikes, rise in prices, depression etc.
2. Temporary or variable working capital: Temporary or variable working capital is the amount of working
capital, which is required to meet the seasonal demands and some special exigencies. Thus the variable
working capital can be further classified into seasonal working capital and special working capital. While
seasonal working capital is required to meet certain seasonal demands, the special working capital is that
part of working capital which is required to meet special exigencies such as launching of extensive
marketing campaigns, for conducting research etc.
Temporary working capital differs from permanent working capital in the sense that it is required for
short periods and cannot be permanently employed gainfully in the business. Figures given below
illustrate the different between permanent and temporary working capital.
Importance of working capital
Working capital is refereed to be the lifeblood and nerve center of a business. Working capital is as essential to
maintain the smooth functioning of a business as blood circulation in a human body. No business can run
successfully with out an adequate amount of working capital. The main advantages of maintaining adequate
amount of working capital are as follows:
1. Solvency of the business: Adequate working capital helps in maintaining solvency of the business
by providing uninterrupted flow of production.
2. Good will: Sufficient working capital enables a business concern to make prompt payment and
hence helps in creating and maintaining good will.
3. Easy loans: A concern having adequate working capital, high solvency and good credit standing
can arrange loans from banks and others on easy and favorable terms.
4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on the
purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw
materials and continuous production.
6. Regular payments of salaries wages and other day to day commitments: A company which has
ample working capital can make regular payment of salaries, wages and other day to day
commitments which raises the morale of its employees, increases their efficiency, reduces
wastage and cost and enhances production and profits.
7. Exploitation of favorable market conditions: The concerns with adequate working capital only
can exploit favorable market conditions such as purchasing its requirements in bulk when the
prices are lower.
8. Ability to face crisis: Adequate working capital enables a concern to face business crisis in
emergencies.
9. Quick and regular return on Investments: Every investor wants a quick and regular return on his
investment. Sufficiency of working capital enables a concern to pay quick and regular dividends
to its investors, as there may not be much pressure to plough back profits. This gains the
confidence of its investors and creates a favorable market to raise additional funds in the future.
10. High morale: Adequacy of working capital creates an environment of security, confidence, and
high morale and creates overall efficiency in a business. Every business concern should have
adequate working capital to run its business operations. It should have neither redundant excess
working capital nor inadequate shortage of working capital. Both, excess as well as short
working capital positions are bad for any business. However, out of the two, it is the inadequacy
of working capital which is more dangerous from the point of view of the firm.
The need or objectives of working capital
The need for working capital arises mainly due to the time gap between production and realization of cash. The
process of production and sale cannot be done instantaneously and hence the firm needs to hold the current assets
to fill-up the time gaps. There are time gaps in purchase of raw materials and production; production and sales:
and sales and realization of cash. The working capital is needed mainly for the following purposes:
1. For the purchase of raw materials.

2. To pay wages, salaries and other day-to-day expenses and overhead cost such as fuel, power and office
expenses, etc.
3. To meet the selling expenses such as packing, advertising, etc.
4. To provide credit facilities to the customers and
5. To maintain the inventories of raw materials, work-in-progress, stores and spares and finishes stock etc.
Generally, the level of working capital needed depends upon the time gap (known as operating cycle) and the size
of operations. Greater the size of the business unit generally, larger will be the requirements of working capital.
The amount of working capital needed also goes on increasing with the growth and expansion of business.
Similarly, the larger the operating cycle, the larger the requirement for working capital. There are many other
factors, which influence the need of working capital in a business, and these are discussed below in the following
pages.
Factors determining the working capital requirements
There are a large number of factors such as the nature and size of business, the character of their operations, the
length of production cycle, the rate of stock turnover and the state of economic situation etc. that decode
requirement of working capital. These factors have different importance and influence on firm differently. In
general following factors generally influence the working capital requirements.
1. Nature or character of business: The working capital requirements of a firm basically depend upon the
nature of its business. Public utility undertakings like electricity, water supply and railways need very
limited working capital as their sales are on cash and are engaged in provision of services only. On the
other hand, trading firms require more investment in inventories, receivables and cash and such they need
large amount of working capital. The manufacturing undertakings also require sizable working capital.
2. Size of business or scale of operations: The working capital requirements of a concern are directly
influenced by the size of its business, which may be measured in terms of scale of operations. Greater the
size of a business unit, generally, larger will be the requirements of working capital. However, in some
cases, even a smaller concern may need more working capital due to high overhead charges, inefficient
use of available resources and other economic disadvantages of small size.
3. Production policy: If the demand for a given product is subject to wide fluctuations due to seasonal
variations, the requirements of working capital, in such cases, depend upon the production policy. The
production could be kept either steady by accumulating inventories during stack periods with a view to
meet high demand during the peck season or the production could be curtailed during the slack season
and increased during the peak season. If the policy is to keep the production steady by accumulating
inventories it will require higher working capital.
4. Manufacturing process/Length of production cycle: In manufacturing business, the requirements of
working capital will be in direct proportion to the length of manufacturing process. Longer the process
period of manufacture, larger is the amount of working capital required, as the raw materials and other
supplies have to be carried for a longer period.
5. Seasonal variations: If the raw material availability is seasonal, they have to be bought in bulk during
the season to ensure an uninterrupted material for the production. A huge amount is, thus, blocked in the
form of material, inventories during such season, which give rise to more working capital requirements.
Generally, during the busy season, a firm requires larger working capital then in the slack season.
6. Working capital cycle: In a manufacturing concern, the working capital cycle starts with the purchase of
raw material and ends with the realization of cash from the sale of finished products. This cycle involves
purchase of raw materials and stores, its conversion into stocks of finished goods through work–in
progress with progressive increment of labour and service costs, conversion of finished stock into sales,
debtors and receivables and ultimately realization of cash. This cycle continues again from cash to
purchase of raw materials and so on. In general the longer the operating cycle, the larger the requirement
of working capital.
7. Credit policy: The credit policy of a concern in its dealings with debtors and creditors influences
considerably the requirements of working capital. A concern that purchases its requirements on credit
requires lesser amount of working capital compared to the firm, which buys on cash. On the other hand, a
concern allowing credit to its customers shall need larger amount of working capital compared to a firm
selling only on cash.
8. Business cycles: Business cycle refers to alternate expansion and contraction in general business activity.
In a period of boom, i.e., when the business is prosperous, there is a need for larger amount of working
capital due to increase in sales. On the contrary, in the times of depression, i.e., when there is a down
swing of the cycle, the business contracts, sales decline, difficulties are faced in collection from debtors
and firms may have to hold large amount of working capital.
9. Rate of growth of business: The working capital requirements of a concern increase with the growth and
expansion of its business activities. The retained profits may provide for a part of working capital but the
fast growing concerns need larger amount of working capital than the amount of undistributed profits.
SOURCE OF FINANCE
Incase of proprietorship business, the individual proprietor generally invests his own savings to start with, and
may borrow money on his personal security or the security of his assets from others. Similarly, the capital of a
partnership from consists partly of funds contributed by the partners and partly of borrowed funds. But the
company from of organization enables the promoters to raise necessary funds from the public who may contribute
capital and become members (share holders) of the company. In course of its business, the company can raise
loans directly from banks and financial institutions or by issue of securities (debentures) to the public. Besides,
profits earned may also be reinvested instead of being distributed as dividend to the shareholders.
Thus for any business enterprise, there are two sources of finance, viz, funds contributed by owners and funds
available from loans and credits. In other words the financial resources of a business may be own funds and
borrowed funds.
Owner funds or ownership capital:
The ownership capital is also known as ‘risk capital’ because every business runs the risk of loss or low profits,
and it is the owner who bears this risk. In the event of low profits they do not have adequate return on their
investment. If losses continue the owners may be unable to recover even their original investment. However, in
times of prosperity and in the case of a flourishing business the high level of profits earned accrues entirely to the
owners of the business. Thus, after paying interest on loans at a fixed rate, the owners may enjoy a much higher
rate of return on their investment. Owners contribute risk capital also in the hope that the value of the firm will
appreciate as a result of higher earnings and growth in the size of the firm.
The second characteristic of this source of finance is that ownership capital remains permanently invested in the
business. It is not refundable like loans or borrowed capital. Hence a large part of it is generally used for a
acquiring long – lived fixed assets and to finance a part of the working capital which is permanently required to
hold a minimum level of stock of raw materials, a minimum amount of cash, etc.
Another characteristic of ownership capital related to the management of business. It is on the basis of their
contribution to equity capital that owners can exercise their right of control over the management of the firm.
Managers cannot ignore the owners in the conduct of business affairs. The sole proprietor directly controls his
own business. In a partnership firm, the active partner will take part in the management of business. A company is
managed by directors who are elected by the members (shareholders).
Merits:
Arising out of its characteristics, the advantages of ownership capital may be briefly stated as follows:
1. It provides risk capital

2. It is a source of permanent capital
3. It is the basis on which owners ‘acquire their right of control over management
4. It does not require security of assets to be offered to raise ownership capital
Limitations:
There are also certain limitations of ownership capital as a source of finance. These are:
The amount of capital, which may be raised as owners fund depends on the number of persons, prepared to take
the risks involved. In a partnership confer, a few persons cannot provide ownership capital beyond a certain limit
and this limitation is more so in case of proprietary form of organization.
A joint stock company can raise large amount by issuing shares to the public. Bus it leads to an increased number
of people having ownership interest and right of control over management. This may reduce the original
investors’ power of control over management. Being a permanent source of capital, ownership funds are not
refundable as long as the company is in existence, even when the funds remain idle.
A company may find it difficult to raise additional ownership capital unless it has high profit-earning capacity or
growth prospects. Issue of additional shares is also subject to so many legal and procedural restrictions.
Borrowed funds and borrowed capital: It includes all funds available by way of loans or credit. Business firms
raise loans for specified periods at fixed rates of interest. Thus borrowed funds may serve the purpose of long-
term, medium-term or short-term finance. The borrowing is generally at against the security of assets from banks
and financial institutions. A company to borrow the funds can also issue various types of debentures.
Interest on such borrowed funds is payable at half yearly or yearly but the principal amount is being repaid only at
the end of the period of loan. These interest and principal payments have to be met even if the earnings are low or
there is loss. Lenders and creditors do not have any right of control over the management of the borrowing firm.
But they can sue the firm in a law court if there is default in payment, interest or principal back.
Merits:
From the business point of view, borrowed capital has several merits.
1. It does not affect the owner’s control over management.
2. Interest is treated as an expense, so it can be charged against income and amount of tax payable thereby
reduced.
3. The amount of borrowing and its timing can be adjusted according to convenience and needs, and
4. It involves a fixed rate of interest to be paid even when profits are very high, thus owners may enjoy a
much higher rate of return on investment then the lenders.
Limitations:
There are certain limitations, too in case of borrowed capacity. Payment of interest and repayment of loans cannot
be avoided even if there is a loss. Default in meeting these obligations may create problems for the business and
result in decline of its credit worthiness. Continuing default may even lead to insolvency of firm.
Secondly, it requires adequate security to be offered against loans. Moreover, high rates of interest may be
charged if the firm’s ability to repay the loan in uncertain.
Source of Company Finance
Based upon the time, the financial resources may be classified into (1) sources of long term (2) sources of short –
term finance. Some of these sources also serve the purpose of medium – term finance.
I. The source of long – term finance are:
1. Issue of shares
2. Issue debentures
3. Loan from financial institutions
4. Retained profits and
5. Public deposits
II. Sources of Short-term Finance are:
1. Trade credit
2. Bank loans and advances and
3. Short-term loans from finance companies.
Sources of Long Term Finance
1. Issue of Shares: The amount of capital decided to be raised from members of the public is divided into
units of equal value. These units are known as share and the aggregate values of shares are known as
share capital of the company. Those who subscribe to the share capital become members of the company
and are called shareholders. They are the owners of the company. Hence shares are also described as
ownership securities.
2. Issue of Preference Shares: Preference share have three distinct characteristics. Preference shareholders
have the right to claim dividend at a fixed rate, which is decided according to the terms of issue of shares.
Moreover, the preference dividend is to be paid first out of the net profit. The balance, it any, can be
distributed among other shareholders that is, equity shareholders. However, payment of dividend is not
legally compulsory. Only when dividend is declared, preference shareholders have a prior claim over
equity shareholders.
Preference shareholders also have the preferential right of claiming repayment of capital in the event of
winding up of the company. Preference capital has to be repaid out of assets after meeting the loan
obligations and claims of creditors but before any amount is repaid to equity shareholders.
Holders of preference shares enjoy certain privileges, which cannot be claimed by the equity
shareholders. That is why; they cannot directly take part in matters, which may be discussed at the
general meeting of shareholders, or in the election of directors.
Depending upon the terms of conditions of issue, different types of preference shares may be issued by a
company to raises funds. Preference shares may be issued as:
1. Cumulative or Non-cumulative
2. Participating or Non-participating
3. Redeemable or Non-redeemable, or as
4. Convertible or non-convertible preference shares.
In the case of cumulative preference shares, the dividend unpaid if any in previous years gets
accumulated until that is paid. No cumulative preference shares have any such provision.
Participatory shareholders are entitled to a further share in the surplus profits after a reasonable divided
has been paid to equity shareholders. Non-participating preference shares do not enjoy such right.
Redeemable preference shares are those, which are repaid after a specified period, where as the
irredeemable preference shares are not repaid. However, the company can also redeem these shares after
a specified period by giving notice as per the terms of issue. Convertible preference shows are those,
which are entitled to be converted into equity shares after a specified period.
Merits:
Many companies due to the following reasons prefer issue of preference shares as a source of finance.
1. It helps to enlarge the sources of funds.

2. Some financial institutions and individuals prefer to invest in preference shares due to the assurance
of a fixed return.
3. Dividend is payable only when there are profits.
4. If does not affect the equity shareholders’ control over management
Limitations:
The limitations of preference shares relates to some of its main features:
1. Dividend paid cannot be charged to the company’s income as an expense; hence there is no tax saving as
in the case of interest on loans.
2. Even through payment of dividend is not legally compulsory, if it is not paid or arrears accumulate there
is an adverse effect on the company’s credit.
3. Issue of preference share does not attract many investors, as the return is generally limited and not exceed
the rates of interest on loan. On the other than, there is a risk of no dividend being paid in the event of
falling income.
1. Issue of Equity Shares: The most important source of raising long-term capital for a company is the issue of
equity shares. In the case of equity shares there is no promise to shareholders a fixed dividend. But if the company
is successful and the level profits are high, equity shareholders enjoy very high returns on their investment. This
feature is very attractive to many investors even through they run the risk of having no return if the profits are
inadequate or there is loss. They have the right of control over the management of the company and their liability
is limited to the value of shares held by them.
From the above it can be said that equity shares have three distinct characteristics:
1. The holders of equity shares are the primary risk bearers. It is the issue of equity shares that mainly
provides ‘risk capital’, unlike borrowed capital. Even compared with preference capital, equity
shareholders are to bear ultimate risk.
2. Equity shares enable much higher return sot be earned by shareholders during prosperity because after
meeting the preference dividend and interest on borrowed capital at a fixed rate, the entire surplus of
profit goes to equity shareholders only.
3. Holders of equity shares have the right of control over the company. Directors are elected on the vote of
equity shareholders.
Merits:
From the company’ point of view; there are several merits of issuing equity shares to raise long-term finance.
1. It is a source of permanent capital without any commitment of a fixed return to the shareholders. The
return on capital depends ultimately on the profitability of business.
2. It facilities a higher rate of return to be earned with the help borrowed funds. This is possible due to two
reasons. Loans carry a relatively lower rate of interest than the average rate of return on total capital.
Secondly, there is tax saving as interest paid can be charged to income as a expense before tax
calculation.
3. Assets are not required to give as security for raising equity capital. Thus additional funds can be raised
as loan against the security of assets.
Limitations:
Although there are several advantages of issuing equity shares to raise long-term capital.
1. The risks of fluctuating returns due to changes in the level of earnings of the company do not attract many
people to subscribe to equity capital.
2. The value of shares in the market also fluctuate with changes in business conditions, this is another risk,
which many investors want to avoid.
2. Issue of Debentures:
When a company decides to raise loans from the public, the amount of loan is dividend into units of equal. These
units are known as debentures. A debenture is the instrument or certificate issued by a company to acknowledge
its debt. Those who invest money in debentures are known as ‘debenture holders’. They are creditors of the
company. Debentures are therefore called ‘creditor ship’ securities. The value of each debentures is generally
fixed in multiplies of 10 like Rs. 100 or Rs. 500, or Rs. 1000.
Debentures carry a fixed rate of interest, and generally are repayable after a certain period, which is specified at
the time of issue. Depending upon the terms and conditions of issue there are different types of debentures. There
are:
a. Secured or unsecured Debentures and

b. Convertible of Non convertible Debentures.
It debentures are issued on the security of all or some specific assets of the company, they are known as secured
debentures. The assets are mortgaged in favor of the debenture holders. Debentures, which are not secured by a
charge or mortgage of any assets, are called unsecured debentures. The holders of these debentures are treated as
ordinary creditors.
Sometimes under the terms of issue debenture holders are given an option to covert their debentures into equity
shares after a specified period. Or the terms of issue may lay down that the whole or part of the debentures will be
automatically converted into equity shares of a specified price after a certain period. Such debentures are known
as convertible debentures. If there is no mention of conversion at the time of issue, the debentures are regarded as
non-convertible debentures.
Merits:
Debentures issue is a widely used method of raising long-term finance by companies, due to the following
reasons.
1. Interest payable on Debentures can be fixed at low rates than rate of return on equity shares. Thus
Debentures issue is a cheaper source of finance.
2. Interest paid can be deducted from income tax purpose; there by the amount of tax payable is reduced.
3. Funds raised for the issue of debentures may be used in business to earn a much higher rate of return then
the rate of interest. As a result the equity shareholders earn more.
4. Another advantage of debenture issue is that funds are available from investors who are not entitled to
have any control over the management of the company.
5. Companies often find it convenient to raise debenture capital from financial institutions, which prefer to
invest in debentures rather than in shares. This is due to the assurance of a fixed return and repayment
after a specified period.
Limitations:
Debenture issue as a source of finance has certain limitations too.
1. It involves a fixed commitment to pay interest regularly even when the company has low earnings or
incurring losses.
2. Debentures issue may not be possible beyond a certain limit due to the inadequacy of assets to be offered
as security.
Methods of Issuing Securities: The firm after deciding the amount to be raised and the type of securities to be
issued, must adopt suitable methods to offer the securities to potential investors. There are for common methods
followed by companies for the purpose.
When securities are offered to the general public a document known as Prospectus, or a notice, circular or
advertisement is issued inviting the public to subscribe to the securities offered thereby all particulars about the
company and the securities offered are made to the public. Brokers are appointed and one or more banks are
authorized to collect subscription.
Some times the entire issue is subscribed by an organization known as Issue House, which in turn sells the
securities to the public at a suitable time.
The company may negotiate with large investors of financial institutions who agree to take over the securities.
This is known as ‘Private Placement’ of securities.
When an exiting company decides to raise funds by issue of equity shares, it is required under law to offer the new
shares to the existing shareholders. This is described as right issue of equity shares. But if the existing
shareholders decline, the new shares can be offered to the public.
3. Loans from financial Institutions:
Government with the main object of promoting industrial development has set up a number of financial
institutions. These institutions play an important role as sources of company finance. Besides they also assist
companies to raise funds from other sources.
These institutions provide medium and long-term finance to industrial enterprises at a reason able rate of interest.
Thus companies may obtain direct loan from the financial institutions for expansion or modernization of existing
manufacturing units or for starting a new unit.
Often, the financial institutions subscribe to the industrial debenture issue of companies some of the institutions
(ICICI) and (IDBI) also subscribe to the share issued by companies.
All such institutions also underwrite the public issue of shares and debentures by companies. Underwriting is an
agreement to take over the securities to the extent there is no public response to the issue. They may guarantee
loans, which may be raised by companies from other sources.
Loans in foreign currency may also be granted for the import of machinery and equipment wherever necessary
from these institutions, which stand guarantee for re-payments. Apart from the national level institutions
mentioned above, there are a number of similar institutions set up in different states of India. The state-level
financial institutions are known as State Financial Corporation, State Industrial Development Corporations, State
Industrial Investment Corporation and the like. The objectives of these institutions are similar to those of the
national-level institutions. But they are mainly concerned with the development of medium and small-scale
industrial units. Thus, smaller companies depend on state level institutions as a source of medium and long-term
finance for the expansion and modernization of their enterprise.
4. Retained Profits:
Successful companies do not distribute the whole of their profits as dividend to shareholders but reinvest a part of
the profits. The amount of profit reinvested in the business of a company is known as retained profit. It is shown
as reserve in the accounts. The surplus profits retained and reinvested may be regarded as an internal source of
finance. Hence, this method of financing is known as self-financing. It is also called sloughing back of profits.
Since profits belong to the shareholders, the amount of retained profit is treated as ownership fund. It serves the
purpose of medium and long-term finance. The total amount of ownership capital of a company can be determined
by adding the share capital and accumulated reserves.
Merits:
This source of finance is considered to be better than other sources for the following reasons.
1. As an internal source, it is more dependable than external sources. It is not necessary to consider
investor’s preference.
2. Use of retained profit does not involve any cost to be incurred for raising the funds. Expenses on
prospectus, advertising, etc, can be avoided.
3. There is no fixed commitment to pay dividend on the profits reinvested. It is a part of risk capital like
equity share capital.
4. Control over the management of the company remains unaffected, as there is no addition to the number of
shareholder.
5. It does not require the security of assets, which can be used for raising additional funds in the form of
loan.
Limitations:
However, there are certain limitations on the part of retained profit.
1. Only well established companies can be avail of this sources of finance. Even for such companies
retained profits cannot be used to an unlimited extent.
2. Accumulation of reserves often attract competition in the market,
3. With the increased earnings, shareholders expect a high rate of dividend to be paid.
4. Growth of companies through internal financing may attract government restrictions as it leads to
concentration of economic power.
5. Public Deposits:
An important source of medium – term finance which companies make use of is public deposits. This requires
advertisement to be issued inviting the general public of deposits. This requires advertisement to be issued
inviting the general public to deposit their savings with the company. The period of deposit may extend up to
three yeas. The rate of interest offered is generally higher than the interest on bank deposits. Against the deposit,
the company mentioning the amount, rate of interest, time of repayment and such other information issues a
receipt.
Since the public deposits are unsecured loans, profitable companies enjoying public confidence only can be able
to attract public deposits. Even for such companies there are rules prescribed by government limited its use.
Sources of Short Term Finance
The major sources of short-term finance are discussed below:
1. Trade credit: Trade credit is a common source of short-term finance available to all companies. It refers
to the amount payable to the suppliers of raw materials, goods etc. after an agreed period, which is
generally less than a year. It is customary for all business firms to allow credit facility to their customers
in trade business. Thus, it is an automatic source of finance. With the increase in production and
corresponding purchases, the amount due to the creditors also increases. Thereby part of the funds
required for increased production is financed by the creditors. The more important advantages of trade
credit as a source of short-term finance are the following:
It is readily available according to the prevailing customs. There are no special efforts to be made to avail
of it. Trade credit is a flexible source of finance. It can be easily adjusted to the changing needs for
purchases.
Where there is an open account for any creditor failure to pay the amounts on time due to temporary
difficulties does not involve any serious consequence Creditors often adjust the time of payment in view
of continued dealings. It is an economical source of finance.
However, the liability on account of trade credit cannot be neglected. Payment has to be made regularly.
If the company is required to accept a bill of exchange or to issue a promissory note against the credit,
payment must be made on the maturity of the bill or note. It is a legal commitment and must be honored;
otherwise legal action will follow to recover the dues.
2. Bank loans and advances: Money advanced or granted as loan by commercial banks is known as bank
credit. Companies generally secure bank credit to meet their current operating expenses. The most
common forms are cash credit and overdraft facilities. Under the cash credit arrangement the maximum
limit of credit is fixed in advance on the security of goods and materials in stock or against the personal
security of directors. The total amount drawn is not to exceed the limit fixed. Interest is charged on the
amount actually drawn and outstanding. During the period of credit, the company can draw, repay and
again draw amounts with in the maximum limit. In the case of overdraft, the company is allowed to
overdraw its current account up to the sanctioned limit. This facility is also allowed either against
personal security or the security of assets. Interest is charged on the amount actually overdrawn, not on
the sanctioned limit.
The advantage of bank credit as a source of short-term finance is that the amount can be adjusted
according to the changing needs of finance. The rate of interest on bank credit is fairly high. But the
burden is no excessive because it is used for short periods and is compensated by profitable use of the
funds.
Commercial banks also advance money by discounting bills of exchange. A company having sold goods
on credit may draw bills of exchange on the customers for their acceptance. A bill is an order in writing
requiring the customer to pay the specified amount after a certain period (say 60 days or 90 days). After
acceptance of the bill, the company can drawn the amount as an advance from many commercial banks
on payment of a discount. The amount of discount, which is equal to the interest for the period of the bill,
and the balance, is available to the company. Bill discounting is thus another source of short-term finance
available from the commercial banks.
3. Short term loans from finance companies: Short-term funds may be available from finance companies
on the security of assets. Some finance companies also provide funds according to the value of bills
receivable or amount due from the customers of the borrowing company, which they take over.
CAPITAL BUDGETING
Capital Budgeting: Capital budgeting is the process of making investment decision in long-term assets or courses
of action. Capital expenditure incurred today is expected to bring its benefits over a period of time. These
expenditures are related to the acquisition & improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a number of years. It is the
process of deciding whether or not to invest in a particular project, as the investment possibilities may not be
rewarding. The manager has to choose a project, which gives a rate of return, which is more than the cost of
financing the project. For this the manager has to evaluate the worth of the projects in-terms of cost and benefits.
The benefits are the expected cash inflows from the project, which are discounted against a standard, generally the
cost of capital.
Capital Budgeting Process:
The capital budgeting process involves generation of investment, proposal estimation of cash-flows for the
proposals, evaluation of cash-flows, selection of projects based on acceptance criterion and finally the continues
revaluation of investment after their acceptance the steps involved in capital budgeting process are as follows.
1. Project generation
2. Project evaluation
3. Project selection
4. Project execution
1. Project generation: In the project generation, the company has to identify the proposal to be undertaken
depending upon its future plans of activity. After identification of the proposals they can be grouped according to
the following categories:
a. Replacement of equipment: In this case the existing outdated equipment and machinery may be
replaced by purchasing new and modern equipment.
b. Expansion: The Company can go for increasing additional capacity in the existing product line
by purchasing additional equipment.
c. Diversification: The Company can diversify its product line by way of producing various
products and entering into different markets. For this purpose, It has to acquire the fixed assets to
enable producing new products.
d. Research and Development: Where the company can go for installation of research and
development suing by incurring heavy expenditure with a view to innovate new methods of
production new products etc.,
2. Project evaluation: In involves two steps.
a. Estimation of benefits and costs: These must be measured in terms of cash flows. Benefits to be
received are measured in terms of cash flows. Benefits to be received are measured in terms of
cash in flows, and costs to be incurred are measured in terms of cash flows.
b. Selection of an appropriate criterion to judge the desirability of the project.
3. Project selection: There is no standard administrative procedure for approving the investment decisions. The
screening and selection procedure would differ from firm to firm. Due to lot of importance of capital budgeting
decision, the final approval of the project may generally rest on the top management of the company. However the
proposals are scrutinized at multiple levels. Some times top management may delegate authority to approve
certain types of investment proposals. The top management may do so by limiting the amount of cash out lay.
Prescribing the selection criteria and holding the lower management levels accountable for the results.
4. Project Execution: In the project execution the top management or the project execution committee is
responsible for effective utilization of funds allocated for the projects. It must see that the funds are spent in
accordance with the appropriation made in the capital budgeting plan. The funds for the purpose of the project
execution must be spent only after obtaining the approval of the finance controller. Further to have an effective
cont. It is necessary to prepare monthly budget reports to show clearly the total amount appropriated, amount
spent and to amount unspent.
Capital budgeting Techniques:
The capital budgeting appraisal methods are techniques of evaluation of investment proposal will help the
company to decide upon the desirability of an investment proposal depending upon their; relative income
generating capacity and rank them in order of their desirability. These methods provide the company a set of
norms on the basis of which either it has to accept or reject the investment proposal. The most widely accepted
techniques used in estimating the cost-returns of investment projects can be grouped under two categories.
1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods
These methods are based on the principles to determine the desirability of an investment project on the basis of its
useful life and expected returns. These methods depend upon the accounting information available from the books
of accounts of the company. These will not take into account the concept of ‘time value of money’, which is a
significant factor to determine the desirability of a project in terms of present value.
A. Pay-back period method: It is the most popular and widely recognized traditional method of evaluating the
investment proposals. It can be defined, as ‘the number of years required to recover the original cash out lay
invested in a project’.
According to Weston & Brigham, “The pay back period is the number of years it takes the firm to recover its
original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to recover initial cash
investment.
The pay back period is also called payout or payoff period. This period is calculated by dividing the cost of the
project by the annual earnings after tax but before depreciation under this method the projects are ranked on the
basis of the length of the payback period. A project with the shortest payback period will be given the highest rank
and taken as the best investment. The shorter the payback period, the less risky the investment is the formula for
payback period is
Cash outlay (or) original cost of project

Pay-back period = -------------------------------------------
Annual cash inflow
Merits:
1. It is one of the earliest methods of evaluating the investment projects.

2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the books.
Demerits:
1. This method fails to take into account the cash flows received by the
company after the pay back period.
2. It doesn’t take into account the interest factor involved in an investment
outlay.
3. It doesn’t take into account the interest factor involved in an investment
outlay.
4. It is not consistent with the objective of maximizing the market value of
the company’s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in flows.
B. Accounting (or) Average rate of return method (ARR):
It is an accounting method, which uses the accounting information repeated by the financial statements to measure
the probability of an investment proposal. It can be determine by dividing the average income after taxes by the
average investment i.e., the average book value after depreciation.
According to ‘Soloman’, accounting rate of return on an investment can be calculated as the ratio of accounting
net income to the initial investment, i.e.,
Average net income after taxes

ARR= ----]--------------------------------- X 100
Average Investment
Total Income after Taxes

Average net income after taxes = -----------------------------
No. Of Years
Total Investment
Average investment = ----------------------
2
On the basis of this method, the company can select all those projects who’s ARR is higher than the minimum rate
established by the company. It can reject the projects with an ARR lower than the expected rate of return. This
method can also help the management to rank the proposal on the basis of ARR. A highest rank will be given to a
project with highest ARR, where as a lowest rank to a project with lowest ARR.
Merits:
1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
Demerits:
1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.
II: Discounted cash flow methods:
The traditional method does not take into consideration the time value of money. They give equal weight age to
the present and future flow of incomes. The DCF methods are based on the concept that a rupee earned today is
more worth than a rupee earned tomorrow. These methods take into consideration the profitability and also time
value of money.
A. Net present value method (NPV)
The NPV takes into consideration the time value of money. The cash flows of different years and valued
differently and made comparable in terms of present values for this the net cash inflows of various period are
discounted using required rate of return which is predetermined.
According to Ezra Solomon, “It is a present value of future returns, discounted at the required rate of return minus
the present value of the cost of the investment.”
NPV is the difference between the present value of cash inflows of a project and the initial cost of the project.
According the NPV technique, only one project will be selected whose NPV is positive or above zero. If a
project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be rejected. If there are more than one
project with positive NPV’s the project is selected whose NPV is the highest.
The formula for NPV is
NPV= Present value of cash inflows – investment.

C1 C2 C3 Cn
NPV = ------ + ------- + -------- + -------
(1+K)
Co- investment
C1, C2, C3… Cn= cash inflows in different years.
K= Cost of the Capital (or) Discounting rate
D= Years.
Merits:
1. It recognizes the time value of money.

2. It is based on the entire cash flows generated during the useful life of the asset.
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining the present value.
Demerits:
1. It is different to understand and use.

2. The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of capital. If
self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different amounts of investment.
4. It does not give correct answer to a question whether alternative projects or limited funds are available
with unequal lines.
B. Internal Rate of Return Method (IRR)
The IRR for an investment proposal is that discount rate which equates the present value of cash inflows with the
present value of cash out flows of an investment. The IRR is also known as cutoff or handle rate. It is usually the
concern’s cost of capital.
According to Weston and Brigham “The internal rate is the interest rate that equates the present value of the
expected future receipts to the cost of the investment outlay.
When compared the IRR with the required rate of return (RRR), if the IRR is more than RRR then the project is
accepted else rejected. In case of more than one project with IRR more than RRR, the one, which gives the
highest IRR, is selected.
The IRR is not a predetermine rate, rather it is to be trial and error method. It implies that one has to start with a
discounting rate to calculate the present value of cash inflows. If the obtained present value is higher than the
initial cost of the project one has to try with a higher rate. Like wise if the present value of expected cash inflows
obtained is lower than the present value of cash flow. Lower rate is to be taken up. The process is continued till
the net present value becomes Zero. As this discount rate is determined internally, this method is called internal
rate of return method.
P1 - Q
IRR = L+ --------- X D
P1 –P2
L- Lower discount rate
P1 - Present value of cash inflows at lower rate.

P2 - Present value of cash inflows at higher rate.
Q- Actual investment
D- Difference in Discount rates.
Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return projects are selected, it
satisfies the investors in terms of the rate of return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.
Demerits:
1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.
C. Probability Index Method (PI)
The method is also called benefit cost ration. This method is obtained cloth a slight modification of the NPV
method. In case of NPV the present value of cash out flows are profitability index (PI), the present value of cash
inflows are divide by the present value of cash out flows, while NPV is a absolute measure, the PI is a relative
measure.
It the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one investment
proposal with the more than one PI the one with the highest PI will be selected. This method is more useful incase
of projects with different cash outlays cash outlays and hence is superior to the NPV method.
The formula for PI is
Present Value of Future Cash Inflow

Probability index = ----------------------------------------
Investment
Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the index.
5. It takes into consideration the entire stream of cash flows generated during the useful life of the asset.
Demerits:
1. It is some what difficult to understand

2. Some people may feel no limitation for index number due to several limitation involved in their
competitions
3. It is very difficult to understand the analytical part of the decision on the basis of probability index.
UNIT - V
INTRODUCTION TO FINANCIAL ACCOUNTING
1. INTRODUCITON
As you are aware, every trader generally starts business for purpose of earning profit. While establishing
business, he brings own capital, borrows money from relatives, friends, outsiders or financial institutions.
Then he purchases machinery, plant , furniture, raw materials and other assets. He starts buying and selling
of goods, paying for salaries, rent and other expenses, depositing and withdrawing cash from bank. Like this
he undertakes innumerable transactions in business. Observe the following transactions of small trader for
one week during the month of July, 1998.
1998 Rs.
July 24 Purchase of goods from Sree Ram 12,000
July 25 Goods sold for cash 5,000
July 25 Sold gods to Syam on credit 8,000
July 26 Advertising expenses 5,200
July 27 Stationary expenses 600
July 27 Withdrawal for personal use 2,500
July 28 Rent paid through cheque 1,000
July 31 Salaries paid 9,000
July 31 Received cash from Syam 5,000
The number of transactions in an organization depends upon the size of the organization. In small
organizations, the transactions generally will be in thousand and in big organizations they may be in lakhs.
As such it is humanly impossible to remember all these transactions. Further, it may not by possible to find
out the final result of the business without recording and analyzing these transactions.
Accounting came into practice as an aid to human memory by maintaining a systematic record of
business transactions.
2. BOOK-KEEPING AND ACCOUNTING
According to G.A. Lee the accounting system has two stages.

1. The making of routine records in the prescribed from and according to set rules of all events with
affect the financial state of the organization; and
2. The summarization from time to time of the information contained in the records, its presentation in
a significant form to interested parties and its interpretation as an aid to decision making by these
parties.
First stage is called Book-Keeping and the second one is Accounting.
Book – Keeping: Book – Keeping involves the chronological recording of financial transactions in a set of
books in a systematic manner.
Accounting: Accounting is concerned with the maintenance of accounts giving stress to the design of the
system of records, the preparation of reports based on the recorded date and the interpretation of the reports.
Distinction between Book – Keeping and Accountancy

Thus, the terms, book-keeping and accounting are very closely related, through there is a subtle
difference as mentioned below.
1. Object : The object of book-keeping is to prepare original books of Accounts. It is restricted to journal,
subsidiary book and ledge accounts only. On the other hand, the main object of accounting is to record
analyse and interpret the business transactions.
2. Level of Work: Book-keeping is restricted to level of work. Clerical work is mainly involved in it.
Accountancy on the other hand, is concerned with all level of management.
3. Principles of Accountancy: In Book-keeping Accounting concepts and conventions will be followed by
all without any difference. On the other hand, various firms follow various methods of reporting and
interpretation in accounting.
3. Final Result: In Book-Keeping it is not possible to know the final result of business every year,
2.1 Meaning of Accounting

Thus, book-keeping is an art of recording the business transactions in the books of original entry and
the ledges. Accountancy begins where Book-keeping ends. Accountancy means the compiliation of accounts
in such a way that one is in a position to know the state of affairs of the business. The work of an accountant
is to analyse, interpret and review the accounts and draw conclusion with a view to guide the management in
chalking out the future policy of the business.
2.2 Definition of Accounting:
Smith and Ashburne: “Accounting is a means of measuring and reporting the results of economic
activities.”
R.N. Anthony: “Accounting system is a means of collecting summarizing, analyzing and reporting in
monetary terms, the information about the business.
American Institute of Certified Public Accountants (AICPA): “The art of recording, classifying and
summarizing in a significant manner and in terms of money transactions and events, which are in part at
least, of a financial character and interpreting the results thereof.”
Thus, accounting is an art of identifying, recording, summarizing and interpreting business
transactions of financial nature. Hence accounting is the Language of Business.
2.3 Branches of Accounting:

The important branches of accounting are:
1. Financial Accounting: The purpose of Accounting is to ascertain the financial results i.e. profit
or loass in the operations during a specific period. It is also aimed at knowing the financial
position, i.e. assets, liabilities and equity position at the end of the period. It also provides other
relevant information to the management as a basic for decision-making for planning and
controlling the operations of the business.
2. Cost Accounting: The purpose of this branch of accounting is to ascertain the cost of a product /
operation / project and the costs incurred for carrying out various activities. It also assist the
management in controlling the costs. The necessary data and information are gatherr4ed form
financial and other sources.
3. Management Accounting : Its aim to assist the management in taking correct policy decision
and to evaluate the impact of its decisions and actions. The data required for this purpose are
drawn accounting and cost-accounting.
4. Inflation Accounting : It is concerned with the adjustment in the values of assest and of profit in
light of changes in the price level. In a way it is concerned with the overcoming of limitations that
arise in financial statements on account of the cost assumption (i.e recording of the assets at their
historical or original cost) and the assumption of stable monetary unit.
5. Human Resource Accounting : It is a branch of accounting which seeks to report and emphasize
the importance of human resources in a company’s earning process and total assets. It is concerned
with the process of identifying and measuring data about human resources and communicating this
information to interested parties. In simple words, it is accounting for people as organizational
resources.
3. FUNCTIONS OF AN ACCOUNTANT
The job of an accountant involves the following types of accounting works :
1. Designing Work : It includes the designing of the accounting system, basis for identification and
classification of financial transactions and events, forms, methods, procedures, etc.
2. Recording Work : The financial transactions are identified, classified and recorded in appropriate
books of accounts according to principles. This is “Book Keeping”. The recording of transactions
tends to be mechanical and repetitive.
3. Summarizing Work : The recorded transactions are summarized into significant form according
to generally accepted accounting principles. The work includes the preparation of profit and loss
account, balance sheet. This phase is called ‘preparation of final accounts’
4. Analysis and Interpretation Work: The financial statements are analysed by using ratio analysis,
break-even analysis, funds flow and cash flow analysis.
5. Reporting Work: The summarized statements along with analysis and interpretation are
communicated to the interested parties or whoever has the right to receive them. For Ex. Share
holders. In addition, the accou8nting departments has to prepare and send regular reports so as to
assist the management in decision making. This is ‘Reporting’.
6. Preparation of Budget : The management must be able to reasonably estimate the future
requirements and opportunities. As an aid to this process, the accountant has to prepare budgets, like
cash budget, capital budget, purchase budget, sales budget etc. this is ‘Budgeting’.
7. Taxation Work : The accountant has to prepare various statements and returns pertaining to
income-tax, sales-tax, excise or customs duties etc., and file the returns with the authorities
concerned.
8. Auditing : It involves a critical review and verification of the books of accounts statements and
reports with a view to verifying their accuracy. This is ‘Auditing’
This is what the accountant or the accounting department does. A person may be placed in any
part of Accounting Department or MIS (Management Information System) Department or in small
organization, the same person may have to attend to all this work.
4. USERS OF ACCOUNTING INFORMATION
Different categories of users need different kinds of information for making decisions. The users of
accounting can be divided in two board groups (1). Internal users and (2). External users.
4.1 Internal Users:

Managers : These are the persons who manage the business, i.e. management at he top, middle and
lower levels. Their requirements of information are different because they make different types of decisions.
Accounting reports are important to managers for evaluating the results of their decisions. In additions to
external financial statements, managers need detailed internal reports either branch division or department or
product-wise. Accounting reports for managers are prepared much more frequently than external reports.
Accounting information also helps the managers in appraising the performance of subordinates. As such
Accounting is termed as “ the eyes and ears of management.”
4.2 External Users :

1. Investors : Those who are interested in buying the shares of company are naturally interested in the financial
statements to know how safe the investment already made is and how safe the proposed investments will be.
2. Creditors : Lenders are interested to know whether their load, principal and interest, will be paid when due.
Suppliers and other creditors are also interested to know the ability of the firm to pay their dues in time.
3. Workers : In our country, workers are entitled to payment of bonus which depends on the size of profit
earned. Hence, they would like to be satisfied that he bonus being paid to them is correct. This knowledge also
helps them in conducting negotiations for wages.
4. Customers : They are also concerned with the stability and profitability of the enterprise. They may be
interested in knowing the financial strength of the company to rent it for further decisions relating to purchase of
goods.
5. Government: Governments all over the world are using financial statements for compiling statistics concerning
business which, in turn, helps in compiling national accounts. The financial statements are useful for tax
authorities for calculating taxes.
6. Public : The public at large interested in the functioning of the enterprises because it may make a
substantial contribution to the local economy in many ways including the number of people employed and their
patronage to local suppliers.
7. Researchers: The financial statements, being a mirror of business conditions, is of great interest to scholars
undertaking research in accounting theory as well as business affairs and practices.
5. ADVANTAGES FROM ACCOUNTING
The role of accounting has changed from that of a mere record keeping during the 1st decade of 20th
century of the present stage, which it is accepted as information system and decision making activity. The
following are the advantages of accounting.
1. Provides for systematic records: Since all the financial transactions are recorded in the books, one need
not rely on memory. Any information required is readily available from these records.
2. Facilitates the preparation of financial statements: Profit and loss accountant and balance sheet can be
easily prepared with the help of the information in the records. This enables the trader to know the net
result of business operations (i.e. profit / loss) during the accounting period and the financial position of the
business at the end of the accounting period.
3. Provides control over assets: Book-keeping provides information regarding cash in had, cash at bank,
stock of goods, accounts receivables from various parties and the amounts invested in various other assets.
As the trader knows the values of the assets he will have control over them.
4. Provides the required information: Interested parties such as owners, lenders, creditors etc., get
necessary information at frequent intervals.
5. Comparative study: One can compare the present performance of the organization with that of its past.
This enables the managers to draw useful conclusion and make proper decisions.
6. Less Scope for fraud or theft: It is difficult to conceal fraud or theft etc., because of the balancing of the
books of accounts periodically. As the work is divided among many persons, there will be check and
counter check.
7. Tax matters: Properly maintained book-keeping records will help in the settlement of all tax matters with
the tax authorities.
8. Ascertaining Value of Business: The accounting records will help in ascertaining the correct value of the
business. This helps in the event of sale or purchase of a business.
9. Documentary evidence: Accounting records can also be used as an evidence in the court to substantiate
the claim of the business. These records are based on documentary proof. Every entry is supported by
authentic vouchers. As such, Courts accept these records as evidence.
10. Helpful to management: Accounting is useful to the management in various ways. It enables the
management to asses the achievement of its performance. The weakness of the business can be identified
and corrective measures can be applied to remove them with the helps accounting.
6. LIMITATIONS OF ACCOUNTING
The following are the limitations of accounting.

1. Does not record all events: Only the transactions of a financial character will be recorded under book-
keeping. So it does not reveal a complete picture about the quality of human resources, locational
advantage, business contacts etc.
2. Does not reflect current values: The data available under book-keeping is historical in nature. So they
do not reflect current values. For instance, we record the value of stock at cost price or market price,
which ever is less. In case of, building, machinery etc., we adopt historical cost as the basis. Infact, the
current values of buildings, plant and machinery may be much more than what is recorded in the balance
sheet.
3. Estimates based on Personal Judgment: The estimate used for determining the values of various items
may not be correct. For example, debtor are estimated in terms of collectibility, inventories are based on
marketability, and fixed assets are based on useful working life. These estimates are based on personal
judgment and hence sometimes may not be correct.
4. Inadequate information on costs and Profits: Book-keeping only provides information about the
overall profitability of the business. No information is given about the cost and profitability of different
activities of products or divisions.
7. BASIC ACCOUNTING CONCEPTS
Accounting has been evolved over a period of several centuries. During this period, certain rules and
conventions have been adopted. They serve as guidelines in identifying the events and transactions to be
accounted for measuring, recording, summarizing and reporting them to the interested parties. These rules and
conventions are termed as Generally Accepted Accounting Principles. These principles are also referred as
standards, assumptions, concepts, conventions doctrines, etc. Thus, the accounting concepts are the fundamental
ideas or basic assumptions underlying the theory and practice of financial accounting. They are the broad working
rules for all accounting activities developed and accepted by the accounting profession.
Basic accounting concepts may be classified into two broad categories.
1. Concept to be observed at the time of recording transactions.(Recording Stage).
2. Concept to be observed at the time of preparing the financial accounts (Reporting Stage)
FINAL ACCOUNTS
INTRODUCTION: The main object of any Business is to make profit. Every trader generally starts business
for the purpose of earning profit. While establishing Business, he brings his own capital, borrows money from
relatives, friends, outsiders or financial institutions, then purchases machinery, plant, furniture, raw materials and
other assets. He starts buying and selling of goods, paying for salaries, rent and other expenses, depositing and
withdrawing cash from Bank. Like this he undertakes innumerable transactions in Business.
The number of Business transactions in an organization depends up on the size of the
organization. In small organizations the transactions generally will be in thousands and in big organizations they
may be in lacks. As such it is humanly impossible to remember all these transactions. Further it may not be
possible to find out the final result of the Business with out recording and analyzing these transactions.
Accounting came in practice as an aid to human memory by maintaining a systematic
record of Business transactions.
BOOK KEEPING AND ACCOUNTING:

According to G.A.Lee the Accounting system has two stages. First stage is Book
keeping and the second stage is accounting.
[A]. BOOK KEEPING:

Book keeping involves the chronological recording of financial transactions in a set of books in a
systematic manner
“Book keeping is the system of recording Business transactions for the purpose of providing
reliable information to the owners and managers about the state and prospect of the Business
concepts”.
Thus Book keeping is an art of recording business transactions in the books of original entry and
the ledges.
[B]. ACCOUNTING: Accounting begins where the Bookkeeping ends

1. SMITH AND ASHBUNNE: Accounting means “measuring and reporting the results of economic activities”.
2. R.N ANTHONY: Accounting is a system of “collecting, summarizing, Analyzing and reporting in monster
terms, the information about the Business”.
3. ICPA: Recording, classifying and summarizing is a significant manner and in terms of money transactions and
events, which are in part at least, of a financial character and interpreting the results there.
Thus accounting is an art of recording, classifying, summarizing and interpreting business transactions of financial
nature. Hence accounting is the “Language of Business”.
ADVANTAGE OF ACCOUNTING
The following are the advantages of Accounting…………
1. PROVIDES FOR SYSTEMATIC RECORDS: Since all the financial transactions are recorded in the
books, one need not rely on memory. Any information required is readily available from these records.
2. FACILITATES THE PRPARATION OF FINANCIAL STATEMENTS: Profit and Loss account and balance
sheet can be easily prepared with the help of the information in the records. This enables the trader to
know the net result of Business operations (i.e. profit/loss) during the accounting period and the financial
position of the business at the end of the accounting period.
3. PROVIDES CONTROL OVER ASSETS: Book keeping provides information regarding cash in hand, cash
at hand, stack of goods, accounts receivable from various parties and the amounts invested in various
other assets. As the trader knows the values of the assets he will have control over them.
4. PROVIES THE REQUIRED INFORMATION: Interested parties such as owners, lenders, creditors etc, get
necessary information at frequent intervals.
5. COMPARITIVE STUDY: One can compare present performance of the organization with that of its past.
This enables the managers to draw useful conclusions and make proper decisions.
6. LESS SCOPE FOR FRAUD OR THEFT: It is difficult to conceal fraud or theft etc. because of the
balancing of the books of accounts periodically. As the work is divided among many persons, there will
be check and counter check.
7. TAX MALTERS: Properly maintained Book keeping records will help in the settlement of all tax
matters with the tax authorities.
8. ASCERTAINING VALUE OF BUSINESS: The accounting records will help in ascertaining the correct
value of the Business. This helps in the event of sale or purchase of a business.
9. DOCUMENTARY EVIDENCE: Accounting records can also be used as evidence in the court of
substantial the claim of the Business. Thus records are based on documentary proof. Authentic vouchers
support every entry. As such, courts accept these records as evidence.
10.HELPFUL TO MANAGEMENT: Accounting is useful to the management in various ways. It enables the
management to assess the achievement of its performance. The weaknesses of the business can be identified
and corrective measures can be applied to remove them with the help of accounting.
LIMITATIONS OF ACCOUNTING
The following are the limitations of accounting…………..
1.DOES NOT RECORD ALL EVENTS: Only the transactions of a financial character will be recorded under
book keeping. So it does not reveal a complete picture about the quality of human resources, locational
advantages, business contacts etc.
2.DOES NOT REFLECT CURRENT VLAUES: The data available under book keeping is historical in nature.
So they do not reflect current values. For instance we record the values of stock at cost price or market price,
which ever is less. In case of building, machinery etc., we adapt historical case as the basis. Infact, the current
values of Buildings, plant and machinery may be much more than what is recorded in the balance sheet.
3. ESTIMATES BASED ON PERSONAL JUDGEMENT: The estimates used for determining the values of
various items may not be correct. For example, debtors are estimated in terms of collectibles, inventories are
based on marketability and fixed assets are based on useful working life. These estimates are based on
personal judgment and hence sometimes may not be correct.
4. INADEQUATE INFORMATION ON COSTS AND PROFITS: Book keeping only provides information
about over all profitability of the business. No information is given about the cost and profitability of
different activities of products or divisions.
BASIC ACCOUNTING CONCEPTS
Accounting is a system evolved to achieve a set of objectives. In order to achieve the goals, we need a set of rules
or guidelines. These guidelines are termed here as “BASIC ACCOUNTING ONCEPTS”. The term concept
means an idea or thought. Basic accounting concepts are the fundamental ideas or basic assumptions underlying
the theory and profit of FINANCIAL ACCOUNTING. These concepts help in bringing about uniformity in the
practice of accounting. In accountancy following concepts are quite popular.
1. BUSINESS ENTITY CONEPT: In this concept “Business is treated as separate from the proprietor”. All the
Transactions recorded in the book of Business and not in the books of proprietor. The proprietor is also treated as
a creditor for the Business.
2. GOING CONCERN CONCEPT: This concept relates with the long life of Business. The assumption is that
business will continue to exist for unlimited period unless it is dissolved due to some reasons or the other.
3. MONEY MEASUREMENT CONCEPT: In this concept “Only those transactions are recorded in accounting
which can be expressed in terms of money, those transactions which can not be expressed in terms of money are
not recorded in the books of accounting”.
4. COST CONCEPT: Accounting to this concept, can asset is recorded at its cost in the books of account. i.e., the
price, which is paid at the time of acquiring it. In balance sheet, these assets appear not at cost price every year,
but depreciation is deducted and they appear at the amount, which is cost, less classification.
5. ACCOUNTING PERIOD CONCEPT: every Businessman wants to know the result of his investment and
efforts after a certain period. Usually one-year period is regarded as an ideal for this purpose. This period is called
Accounting Period. It depends on the nature of the business and object of the proprietor of business.
6. DUAL ASCEPT CONCEPT: According to this concept “Every business transactions has two aspects”, one is
the receiving benefit aspect another one is giving benefit aspect. The receiving benefit aspect is termed as
“DEBIT”, where as the giving benefit aspect is termed as “CREDIT”. Therefore, for every debit, there will be
corresponding credit.
7. MATCHING COST CONCEPT: According to this concept “The expenses incurred during an accounting period,
e.g., if revenue is recognized on all goods sold during a period, cost of those good sole should also
Be charged to that period.
8. REALISATION CONCEPT: According to this concept revenue is recognized when a sale is made. Sale is
Considered to be made at the point when the property in goods posses to the buyer and he becomes legally liable
to pay.
ACCOUNTING CONVENTIONS
Accounting is based on some customs or usages. Naturally accountants here to adopt that usage or custom.
They are termed as convert conventions in accounting. The following are some of the important accounting
conventions.
1.FULL DISCLOSURE: According to this convention accounting reports should disclose fully and fairly the
information. They purport to represent. They should be prepared honestly and sufficiently disclose information
which is if material interest to proprietors, present and potential creditors and investors. The companies ACT,
1956 makes it compulsory to provide all the information in the prescribed form.
2.MATERIALITY: Under this convention the trader records important factor about the commercial activities. In the
form of financial statements if any unimportant information is to be given for the sake of clarity it will be given as
footnotes.
3.CONSISTENCY: It means that accounting method adopted should not be changed from year to year. It means
that there should be consistent in the methods or principles followed. Or else the results of a year
Cannot be conveniently compared with that of another.
4. CONSERVATISM: This convention warns the trader not to take unrealized income in to account. That is why
the practice of valuing stock at cost or market price, which ever is lower is in vague. This is the policy of “playing
safe”; it takes in to consideration all prospective losses but leaves all prospective profits.
KEY WORDS IN BOOK-KEEPING
1. TRANSACTIONS: Any sale or purchase of goods of services is called the transaction.

Transactions are two types.
[a]. cash transaction: cash transaction is one where cash receipt or payment is
involved in the exchange.
[b]. Credit transaction: Credit transaction will not have cash, either received or
paid, for something given or received respectively.
2.GOODS: Fill those things which a firm purchases for resale are called goods.
3.PURCHASES: Purchases means purchase of goods, unless it is stated otherwise it also represents the
Goods purchased.
4.SALES: Sales means sale of goods, unless it is stated otherwise it also represents these goods sold.
5.EXPENSES: Payments for the purchase of goods as services are known as expenses.
6.REVENUE: Revenue is the amount realized or receivable from the sale of goods or services.
7.ASSETS: The valuable things owned by the business are known as assets. These are the properties
Owned by the business.
8.LIABILITIES: Liabilities are the obligations or debts payable by the enterprise in future in the term
Of money or goods.
9. DEBTORS: Debtors means a person who owes money to the trader.
10.CREDITORS: A creditor is a person to whom something is owned by the business.
11.DRAWINGS: cash or goods withdrawn by the proprietor from the Business for his personal or
Household is termed to as “drawing”.
12.RESERVE: An amount set aside out of profits or other surplus and designed to meet contingencies.
13.ACCOUNT: A summarized statements of transactions relating to a particular person, thing,

Expense or income.
14.DISCOUNT: There are two types of discounts..

a. cash discount: An allowable made to encourage frame payment or before the
expiration of the period allowed for credit.
b. Trade discount: A deduction from the gross or catalogue price allowed to traders
who buys them for resale.
CLASSIFICATION OF BUSINESS TRANSACTIONS
All business transactions are classified into three categories:

1.Those relating to persons
2.Those relating to property(Assets)
3.Those relating to income & expenses
Thus, three classes of accounts are maintained for recording all business transactions. They are:
1.Personal accounts
2.Real accounts
3.Nominal accounts
1.Personal Accounts :Accounts which are transactions with persons are called “Personal Accounts” .
A separate account is kept on the name of each person for recording the benefits received from ,or given to the
person in the course of dealings with him.
E.g.: Krishna’s A/C, Gopal’s A/C, SBI A/C, Nagarjuna Finanace Ltd.A/C, ObulReddy & Sons A/C , HMT Ltd.
A/C, Capital A/C, Drawings A/C etc.
2.Real Accounts: The accounts relating to properties or assets are known as “Real Accounts” .Every business
needs assets such as machinery , furniture etc, for running its activities .A separate account is maintained for each
asset owned by the business .
E.g.: cash A/C, furniture A/C, building A/C, machinery A/C etc.
3.NominalAccounts:Accounts relating to expenses, losses, incomes and gains are known as “Nominal Accounts”.
A separate account is maintained for each item of expenses, losses, income or gain.
E.g.: Salaries A/C, stationery A/C, wages A/C, postage A/C, commission A/C, interest A/C, purchases A/C, rent
A/C, discount A/C, commission received A/C, interest received A/C, rent received A/C, discount received A/C.
Before recording a transaction, it is necessary to find out which of the accounts is to be debited and which is to be
credited. The following three different rules have been laid down for the three classes of accounts….
1.Personal Accounts: The account of the person receiving benefit (receiver) is to be debited and the account of the
person giving the benefit (given) is to be credited.
Rule: “Debit----The Receiver

Credit---The Giver”
2.Real Accounts: When an asset is coming into the business, account of that asset is to be debited .When an asset
is going out of the business, the account of that asset is to be credited.
Rule: “Debit----What comes in

Credit---What goes out”
3. Nominal Accounts: When an expense is incurred or loss encountered, the account representing the expense or
loss is to be debited . When any income is earned or gain made, the account representing the income of gain is to
be credited.
Rule: “Debit----All expenses and losses

Credit---All incomes and gains”
JOURNAL
The first step in accounting therefore is the record of all the transactions in the books of original entry viz., Journal
and then posting into ledges.
JOURNAL: The word Journal is derived from the Latin word ‘journ’ which means a day. Therefore, journal
means a ‘day Book’ in day-to-day business transactions are recorded in chronological order.
Journal is treated as the book of original entry or first entry or prime entry. All the business transactions are
recorded in this book before they are posted in the ledges. The journal is a complete and chronological(in order of
dates) record of business transactions. It is recorded in a systematic manner. The process of recording a
transaction in the journal is called “JOURNALISING”. The entries made in the book are called “Journal Entries”.
The proforma of Journal is given below.
Date Date Particulars L.F. no Debit Credit

RS. RS.
1998 Jan 1 Purchases account to cash 10,000/- 10,000/-

account(being goods purchased for
cash)
LEDGER
All the transactions in a journal are recorded in a chronological order. After a certain period, if we want to know
whether a particular account is showing a debit or credit balance it becomes very difficult. So, the ledger is
designed to accommodate the various accounts maintained the trader. It contains the final or permanent record of
all the transactions in duly classified form. “A ledger is a book which contains various accounts.” The process of
transferring entries from journal to ledger is called “POSTING”.
Posting is the process of entering in the ledger the entries given in the journal. Posting into ledger is done
periodically, may be weekly or fortnightly as per the convenience of the business. The following are the
guidelines for posting transactions in the ledger.
1. After the completion of Journal entries only posting is to be made in the ledger.
2. For each item in the Journal a separate account is to be opened. Further, for each new item a new
account is to be opened.
3. Depending upon the number of transactions space for each account is to be determined in the ledger.
4. For each account there must be a name. This should be written in the top of the table. At the end of the
name, the word “Account” is to be added.
5. The debit side of the Journal entry is to be posted on the debit side of the account, by starting with
“TO”.
6. The credit side of the Journal entry is to be posted on the debit side of the account, by starting with
“BY”.
Proforma for ledger: LEDGER BOOK
Particulars account
Date Particulars Lfno Amount Date Particulars Lfno amount
sales account
cash account
TRAIL BALANCE
The first step in the preparation of final accounts is the preparation of trail balance. In the double entry system of
book keeping, there will be credit for every debit and there will not be any debit without credit. When this
principle is followed in writing journal entries, the total amount of all debits is equal to the total amount all
credits.
A trail balance is a statement of debit and credit balances. It is prepared on a particular date with the object of
checking the accuracy of the books of accounts. It indicates that all the transactions for a particular period have
been duly entered in the book, properly posted and balanced. The trail balance doesn’t include stock in hand at the
end of the period. All adjustments required to be done at the end of the period including closing stock are
generally given under the trail balance.
DEFINITIONS: SPICER AND POGLAR :A trail balance is a list of all the balances standing on the ledger
accounts and cash book of a concern at any given date.
J.R.BATLIBOI:
A trail balance is a statement of debit and credit balances extracted from the ledger with a view to test the
arithmetical accuracy of the books.
Thus a trail balance is a list of balances of the ledger accounts’ and cash book of a business concern at any given
date.
PROFORMA FOR TRAIL BALANCE:

Trail balance for MR…………………………………… as on …………
NO NAME OF ACCOUNT DEBIT CREDIT
(PARTICULARS) AMOUNT(RS.) AMOUNT(RS.)
Trail Balance
Specimen of trial balance
1 Capital Credit Loan

2 Opening stock Debit Asset
3 Purchases Debit Expense
4 Sales Credit Gain
5 Returns inwards Debit Loss
6 Returns outwards Debit Gain
7 Wages Debit Expense
8 Freight Debit Expense
9 Transport expenses Debit Expense
10 Royalities on production Debit Expense

11 Gas, fuel Debit Expense
12 Discount received Credit Revenue
13 Discount allowed Debit Loss
14 Bas debts Debit Loss
15 Dab debts reserve Credit Gain
16 Commission received Credit Revenue
17 Repairs Debit Expense
18 Rent Debit Expense
19 Salaries Debit Expense
20 Loan Taken Credit Loan
21 Interest received Credit Revenue
22 Interest paid Debit Expense
23 Insurance Debit Expense
24 Carriage outwards Debit Expense
25 Advertisements Debit Expense
26 Petty expenses Debit Expense
27 Trade expenses Debit Expense
28 Petty receipts Credit Revenue
29 Income tax Debit Drawings
30 Office expenses Debit Expense
31 Customs duty Debit Expense
32 Sales tax Debit Expense
33 Provision for discount on debtors Debit Liability
34 Provision for discount on creditors Debit Asset
35 Debtors Debit Asset
36 Creditors Credit Liability
37 Goodwill Debit Asset
38 Plant, machinery Debit Asset
39 Land, buildings Debit Asset
40 Furniture, fittings Debit Asset
41 Investments Debit Asset
42 Cash in hand Debit Asset
43 Cash at bank Debit Asset
44 Reserve fund Credit Liability
45 Loan advances Debit Asset
46 Horse, carts Debit Asset
47 Excise duty Debit Expense
48 General reserve Credit Liability
49 Provision for depreciation Credit Liability
50 Bills receivable Debit Asset
51 Bills payable Credit Liability
52 Depreciation Debit Loss

53 Bank overdraft Credit Liability
54 Outstanding salaries Credit Liability
55 Prepaid insurance Debit Asset
56 Bad debt reserve Credit Revenue
57 Patents & Trademarks Debit Asset
58 Motor vehicle Debit Asset
59 Outstanding rent Credit Revenue
FINAL ACCOUNTS
In every business, the business man is interested in knowing whether the business has resulted in profit or
loss and what the financial position of the business is at a given time. In brief, he wants to know (i)The
profitability of the business and (ii) The soundness of the business.
The trader can ascertain this by preparing the final accounts. The final accounts are prepared from the
trial balance. Hence the trial balance is said to be the link between the ledger accounts and the final accounts. The
final accounts of a firm can be divided into two stages. The first stage is preparing the trading and profit and loss
account and the second stage is preparing the balance sheet.
TRADING ACCOUNT
The first step in the preparation of final account is the preparation of trading account. The main purpose
of preparing the trading account is to ascertain gross profit or gross loss as a result of buying and selling the
goods.
Trading account of MR……………………. for the year ended ……………………
Particulars Amount Particulars Amount
To opening stock Xxxx By sales xxxx

To purchases xxxx Less: returns xxx Xxxx
Less: returns xx Xxxx By closing stock Xxxx
To carriage inwards Xxxx

To wages Xxxx
To freight Xxxx
To customs duty, octroi Xxxx
To gas, fuel, coal,

Water Xxxx
To factory expenses
To other man. Expenses Xxxx
To productive expenses Xxxx
To gross profit c/d
Xxxx
Xxxx
Xxxx
Xxxx
Finally, a ledger may be defined as a summary statement of all the transactions relating to a person , asset,
expense or income which have taken place during a given period of time. The up-to-date state of any account can
be easily known by referring to the ledger.
PROFIT AND LOSS ACCOUNT
The business man is always interested in knowing his net income or net profit.Net profit represents the excess of
gross profit plus the other revenue incomes over administrative, sales, Financial and other expenses. The debit
side of profit and loss account shows the expenses and the credit side the incomes. If the total of the credit side is
more, it will be the net profit. And if the debit side is more, it will be net loss.
PROFIT AND LOSS A/C OF MR…………………….FOR THE YEAR ENDED…………

PARTICULARS AMOUNT PARTICULARS AMOUNT
TO office salaries Xxxxxx By gross profit b/d Xxxxx
TO rent,rates,taxes Xxxxx Interest received Xxxxx
TO Printing and stationery Xxxxx Discount received Xxxx
TO Legal charges Commission received Xxxxx
Audit fee Xxxx Income from investments
TO Insurance Xxxx Dividend on shares
TO General expenses Xxxx Miscellaneous investments Xxxx
TO Advertisements Xxxxx Rent received Xxxx
TO Bad debts Xxxx
TO Carriage outwards Xxxx xxxx
TO Repairs Xxxx
TO Depreciation Xxxxx
TO interest paid Xxxxx
TO Interest on capital Xxxxx
TO Interest on loans Xxxx
TO Discount allowed Xxxxx
TO Commission Xxxxx
TO Net profit------- Xxxxx
(transferred to capital a/c)
xxxxxx Xxxxxx
BALANCE SHEET
The second point of final accounts is the preparation of balance sheet. It is prepared often in the trading and profit,
loss accounts have been compiled and closed. A balance sheet may be considered as a statement of the financial
position of the concern at a given date.
DEFINITION: A balance sheet is an item wise list of assets, liabilities and proprietorship of a business at a
certain state.
J.R.botliboi: A balance sheet is a statement with a view to measure exact financial position of a business at a
particular date.
Thus, Balance sheet is defined as a statement which sets out the assets and liabilities of a business firm and which
serves to as certain the financial position of the same on any particular date. On the left-hand side of this
statement, the liabilities and the capital are shown. On the right-hand side all the assets are shown. Therefore, the
two sides of the balance sheet should be equal. Otherwise, there is an error somewhere.
BALANCE SHEET OF ………………………… AS ON …………………………………….

Liabilities and capital Amount Assets Amount
Creditors Xxxx Cash in hand Xxxx

Bills payable Xxxx Cash at bank Xxxx
Bank overdraft Xxxx Bills receivable Xxxx
Loans Xxxx Debtors Xxxx
Mortgage Xxxx Closing stock Xxxx
Reserve fund Xxxx Investments Xxxx
Capital xxxxxx Furniture and fittings Xxxx
Add: Plats&machinery
Net Profit xxxx Land & buildings Xxxx
------- Patents, tm ,copyrights Xxxx
xxxxxxx Goodwill Xxxx
-------- Prepaid expenses
Outstanding incomes Xxxx
Less: Xxxx
Drawings xxxx Xxxx Xxxx
--------- XXXX XXXX
Advantages: The following are the advantages of final balance .

1. It helps in checking the arithmetical accuracy of books of accounts.
2. It helps in the preparation of financial statements.
3. It helps in detecting errors.
4. It serves as an instrument for carrying out the job of rectification of entries.
5. It is possible to find out the balances of various accounts at one place.
FINAL ACCOUNTS -- ADJUSTMENTS
We know that business is a going concern. It has to be carried on indefinitely. At the end of every accounting
year. The trader prepares the trading and profit and loss account and balance sheet. While preparing these
financial statements, sometimes the trader may come across certain problems .The expenses of the current year
may be still payable or the expenses of the next year have been prepaid during the current year. In the same way,
the income of the current year still receivable and the income of the next year have been received during the
current year. Without these adjustments, the profit figures arrived at or the financial position of the concern may
not be correct. As such these adjustments are to be made while preparing the final accounts.
The adjustments to be made to final accounts will be given under the Trial Balance. While making the adjustment
in the final accounts, the student should remember that “every adjustment is to be made in the final accounts twice
i.e. once in trading, profit and loss account and later in balance sheet generally”. The following are some of the
important adjustments to be made at the time of preparing of final accounts:-
1. CLOSING STOCK :-
(i)If closing stock is given in Trail Balance: It should be shown only in the balance sheet “Assets Side”.
(ii)If closing stock is given as adjustment :
1. First, it should be posted at the credit side of “Trading Account”.

2. Next, shown at the asset side of the “Balance Sheet”.
2.OUTSTANDING EXPENSES :-
(i)If outstanding expenses given in Trail Balance: It should be only on the liability side of Balance Sheet.
(ii)If outstanding expenses given as adjustment :

1. First, it should be added to the concerned expense at the
debit side of profit and loss account or Trading Account.
2. Next, it should be added at the liabilities side of the
Balance Sheet.
3.PREAPID EXPENSES :-
(i)If prepaid expenses given in Trial Balance: It should be shown only in assets side of the Balance Sheet.
(ii)If prepaid expense given as adjustment :
1. First, it should be deducted from the concerned expenses at the debit side of profit and loss account or
Trading Account.
2. Next, it should be shown at the assets side of the Balance Sheet.
4.INCOME EARNED BUT NOT RECEIVED [OR] OUTSTANDING INCOME [OR] ACCURED INCOME :-
(i)If incomes given in Trial Balance: It should be shown only on the assets side of the Balance Sheet.
(ii)If incomes outstanding given as adjustment:
1. First, it should be added to the concerned income at the credit side of profit and loss account.
2. Next, it should be shown at the assets side of the Balance sheet.
5. INCOME RECEIVED IN ADVANCE: UNEARNED INCOME:-

(i)If unearned incomes given in Trail Balance : It should be shown only on the liabilities side of the Balance
Sheet.
(ii)If unearned income given as adjustment :

1. First, it should be deducted from the concerned income in the credit side of the profit and loss account.
2. Secondly, it should be shown in the liabilities side of the
Balance Sheet.
6.DEPRECIATION:-
(i)If Depreciation given in Trail Balance: It should be shown only on the debit side of the profit and loss account.
(ii)If Depreciation given as adjustment

1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deduced from the concerned asset in the Balance sheet assets side.
7.INTEREST ON LOAN [OR] CAPITAL :-

(i)If interest on loan (or) capital given in Trail balance :It should be shown only on debit side of the profit and
loss account.
(ii)If interest on loan (or)capital given as adjustment :
1. First, it should be shown on debit side of the profit and loss account.
2. Secondly, it should added to the loan or capital in
the liabilities side of the Balance Sheet.
8.BAD DEBTS:-
(i)If bad debts given in Trail balance :It should be shown on the debit side of the profit and loss account.
(ii)If bad debts given as adjustment:

1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deducted from debtors in the assets side of the Balance Sheet.
9.INTEREST ON DRAWINGS :-
(i)If interest on drawings given in Trail balance: It should be shown on the credit side of the profit and loss
account.
(ii)If interest on drawings given as adjustments :

1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be deducted from capital on liabilities
side of the Balance Sheet.
10.INTEREST ON INVESTMENTS :-
(i)If interest on the investments given in Trail balance :It should be shown on the credit side of the profit and loss
account.
(ii)If interest on investments given as adjustments :
1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be added to the investments on assets side of the Balance Sheet.
Note: Problems to be solved on final accounts
SUBSIDIARY BOOKS
In a small business concern, the numbers of transactions are limited. These transactions are first recorded in the
journal as and when they take place. Subsequently, these transactions are posted in the appropriate accounts of the
ledger. Therefore, the journal is known as “Book Of Original Entry” or “Book of Prime Entry” while the ledger is
known as main book of accounts.
On the other hand, the transactions in big concern are numerous and sometimes even run into thousands and lakhs.
It is inconvenient and time wasting process if all the transactions are going to be managed with a journal.
Therefore, a convenient device is made. Smaller account books known as subsidiary books or subsidiary journals
are disturbed to various sections of the business house. As and when transactions take place, they are recorded in
these subsidiary books simultaneously without delay. The original journal (which is known as Journal Proper) is
used only occasionally to record those transactions which cannot be recorded in any of the subsidiary books.
TYPES OF SUBSIDIARY BOOKS:-- Subsidiary books are divided into eight types. They are,
1.Purchases Book
2.Sales Book
3.Purchase Returns Book
4.Sales Returns Book

5.Cash Book
6.Bills Receivable Book
7.Bills Payable Book
8.Journal Proper
1. PURCHASES BOOK :- This book records all credit purchases only. Purchase of goods for cash and purchase
of assets for cash. Credit will not be recorded in this book. Purchases book is otherwise called Purchases Day
Book, Purchases Journal or Purchases Register.
2. SALES BOOK :-This book is used to record credit sales only. Goods are sold for cash and sale of assets for
cash or credit will not be recorded in this book. This book is otherwise called Sales Day Book, Sales Journal or
Sales Register.
3.PURCHASE RETURNS BOOK :- This book is used to record the particulars of goods returned to the suppliers
.This book is otherwise called Returns Outward Book.
4.SALES RETURNS BOOK :- This book is used to record the particulars of goods returned by the customers.
This book is otherwise called Returns Inward Book.
5.CASH BOOK :- All cash transactions , receipts and payments are recorded in this book. Cash includes cheques,
money orders etc.
6.BILLS REECEIVABLE BOOK :- This book is used to record all the bills and promissory notes are received
from the customers.
7.BILLS PAYABLE BOOK :- This book is used to record all the bills or promissory notes accepted to the
suppliers.
8.JOURNAL PROPER :- This is used to record all the transactions that cannot be recorded in any of the above
mentioned subsidiary books.
FORMAT FOR PURCHASE BOOK
Date Name of supplier Invoice Lf no Details Amount(Rs.)

No
FORMAT FOR SALES BOOK
Date Name of customer Invoice Lf no Details Amount(Rs.)
No
FORMAT FOR PURCHASE RETURNS BOOK
Date Name of supplier Debit Lf no Details Amount(Rs.)

note
No
FORMAT FOR SALES RETURNS BOOK

Date Name of supplier Credit Lf no Details Amount(Rs.)
note
No
CASH BOOK
Cash book plays an important role in accounting. Whether transactions made are in the form of cash or credit,
final statement will be in the form of receipt or payment of cash. So, every transaction finds place in the cash book
finally.
Cash book is a principal book as well as the subsidiary book. It is a book of original entry since the transactions
are recorded for the first time from the source of documents. It is a ledger in a sense it is designed in the form of
cash account and records cash receipts on the debit side and the cash payments on the credit side. Thus, a cash
book fulfils the functions of both a ledger account and a journal.
Cash book is divided into two sides. Receipt side (debit side) and payment side (credit side). The method of
recording cash sample is very simple. All cash receipts will be posted on the debit side and all the payments will
be recorded on the credit side.
Types of cash book: cash book may be of the following types according to the needs of the business.
 Simple cash book

 Double column or two column cash book
 Three column cash book
 Petty cash book
SINGLE COLUMN CASH BOOK: The simple cash book is a record of only cash transactions. The model of
the cash book is given below.
CASH BOOK
Date Particul Lf no Amount Date Particulars Lf no Amou

ars nt
TWO COLUMN CASH BOOK: This book has two columns on each side one for discount and the other for cash.
Discount column on debit side represents loss being discount allowed to customers. Similarly, discount column on
credit side represents gain being discount received.
Discount may be two types.
(i)Trade discount
(ii)cash discount
TRADE DISCOUNT: when a retailer purchases goods from the wholesaler, he allows some discount on the
catalogue price. This discount is called as Trade discount. Trade discount is adjusted in the invoice and the net
amount is recorded in the purchase book. As such it will not appear in the book of accounts.
CASH DISCOUNT: When the goods are purchased on credit, payment will be made in the future as agreed by the
parties. If the amount is paid early as promptly a discount by a way of incentive will be allowed by the seller to
the buyer. This discount is called as cash discount. So cash discount is the discount allowed by the seller to
encourage prompt payment from the buyer. Cash discount is entered in the discount column of the cash book. The
discount recorded in the debit side of the cash book is discount allowed. The discount recorded in the credit side
of the cash book is discount received.
CASH DISCOUNT COLUMN CASH BOOK
Date particulars Lf no Disc. cash Date Particulars Lf Disc cash

Allo No Recei
wed Ved.
PETTY CASH BOOK: We have seen that all the cash receipts and payments will be recorded in the cash book. But
in the case of big concerns if all transactions like postage, cleaning charges, etc., are recorded in the cash book, the
cash book becomes bulky and un wieldy. So, all petty disbursement of cash is recorded in a separate cash book
called petty cash book.
Note: Problems to be solved on subsidiary books
FINANCIAL ANALYSIS THROUGH RATIOS
Ratio Analysis
Absolute figures are valuable but they standing alone convey no meaning unless compared with another.
Accounting ratio show inter-relationships which exist among various accounting data. When relationships among
various accounting data supplied by financial statements are worked out, they are known as accounting ratios.
Accounting ratios can be expressed in various ways such as:

1. a pure ratio says ratio of current assets to current liabilities is 2:1 or
2. a rate say current assets are two times of current liabilities or
3. a percentage say current assets are 200% of current liabilities.
Each method of expression has a distinct advantage over the other the analyst will selected that mode which will
best suit his convenience and purpose.
Uses or Advantages or Importance of Ratio Analysis
Ratio Analysis stands for the process of determining and presenting the relationship of items and groups of items
in the financial statements. It is an important technique of financial analysis. It is a way by which financial
stability and health of a concern can be judged. The following are the main uses of Ratio analysis:
(i) Useful in financial position analysis: Accounting reveals the financial position of the concern. This helps
banks, insurance companies and other financial institution in lending and making investment decisions.
(ii) Useful in simplifying accounting figures: Accounting ratios simplify, summaries and systematic the
accounting figures in order to make them more understandable and in lucid form.
(iii) Useful in assessing the operational efficiency: Accounting ratios helps to have an idea of the working of a
concern. The efficiency of the firm becomes evident when analysis is based on accounting ratio. This helps
the management to assess financial requirements and the capabilities of various business units.
(iv) Useful in forecasting purposes: If accounting ratios are calculated for number of years, then a trend is
established. This trend helps in setting up future plans and forecasting.
(v) Useful in locating the weak spots of the business: Accounting ratios are of great assistance in locating the
weak spots in the business even through the overall performance may be efficient.
(vi) Useful in comparison of performance: Managers are usually interested to know which department
performance is good and for that he compare one department with the another department of the same firm.
Ratios also help him to make any change in the organisation structure.
Limitations of Ratio Analysis: These limitations should be kept in mind while making use of ratio analyses
for interpreting the financial statements. The following are the main limitations of ratio analysis.
1. False results if based on incorrect accounting data: Accounting ratios can be correct only if the data (on
which they are based) is correct. Sometimes, the information given in the financial statements is affected
by window dressing, i. e. showing position better than what actually is.
2. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past financial
statements; so they are historical documents. Now-a-days keeping in view the complexities of the
business, it is important to have an idea of the probable happenings in future.
3. Variation in accounting methods: The two firms’ results are comparable with the help of accounting
ratios only if they follow the some accounting methods or bases. Comparison will become difficult if the
two concerns follow the different methods of providing depreciation or valuing stock.
4. Price level change: Change in price levels make comparison for various years difficult.
5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of information
needed for decision-making so, to have a comprehensive analysis of financial statements, ratios should be
used along with other methods of analysis.
6. No common standards: It is very difficult to by down a common standard for comparison because
circumstances differ from concern to concern and the nature of each industry is different.
7. Different meanings assigned to the some term: Different firms, in order to calculate ratio may assign
different meanings. This may affect the calculation of ratio in different firms and such ratio when used for
comparison may lead to wrong conclusions.
8. Ignores qualitative factors: Accounting ratios are tools of quantitative analysis only. But sometimes
qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis
under such circumstances may get distorted.
9. No use if ratios are worked out for insignificant and unrelated figure: Accounting ratios should be
calculated on the basis of cause and effect relationship. One should be clear as to what cause is and what
effect is before calculating a ratio between two figures.
Ratio Analysis: Ratio is an expression of one number is relation to another. It is one of the methods of analyzing
financial statement. Ratio analysis facilities the presentation of the information of the financial statements in
simplified and summarized from. Ratio is a measuring of two numerical positions. It expresses the relation
between two numeric figures. It can be found by dividing one figure by another ratios are expressed in three ways.
1. Jines method
2. Ratio Method
3. Percentage Method
Classification of ratios: All the ratios broadly classified into four types due to the interest of different parties for
different purposes. They are:
1. Profitability ratios
2. Turn over ratios
3. Financial ratios
4. Leverage ratios
1. Profitability ratios: These ratios are calculated to understand the profit positions of the business. These
ratios measure the profit earning capacity of an enterprise. These ratios can be related its save or capital to
a certain margin on sales or profitability of capital employ. These ratios are of interest to management.
Who are responsible for success and growth of enterprise? Owners as well as financiers are interested in
profitability ratios as these reflect ability of enterprises to generate return on capital employ important
profitability ratios are:
Profitability ratios in relation to sales: Profitability ratios are almost importance of concern. These ratios
are calculated is focus the end results of the business activities which are the sole eritesiour of overall
efficiency of organisation.
gross profit
1. Gross profit ratio: x 100
Nest sales
Note: Higher the ratio the better it is
Net profit after interest & Tax

2. Net profit ratio: X 100
Net sales
3. Operating ratio (Operating expenses ratio)
Cost of goods sold  operating exenses

X 100
Net sales
Net: Lower the ratio the better it is
Operating profit
4. Operating profit ratio: X 100 = 100 operating ratio
Net sales
Note: Higher the ratio the better it is cost of goods sold= opening stock + purchase + wages + other direct
expenses- closing stock (or) sales – gross profit.
Operating expenses:
= administration expenses + setting, distribution expenses operating profit= gross profit – operating
expense.
concern expense
Expenses ratio = X 100
Net sales
Note: Lower the ratio the better it is
Profitability ratios in relation to investments:
Net profit after tax & latest depreciation

1. Return on investments: X 100
share holders funds
Share holders funds = equity share capital + preference share capital + receives & surpluses +undistributed
profits.
Net Profit after tax & interest - preference divident

2. Return on equity capital: X 100
equity share capital
Net profit after tax - preferecne divident

3. Earnings per share=
No. of equity shares
operating profit
4. Return on capital employed = x 100
capital employed
N. P. after tax and interest
5. Return on total assets =
Total Assets
Here, capital employed = equity share capital + preference share capital + reserves & surpluses +
undistributed profits + debentures+ public deposit + securities + long term loan + other long term liability –
factious assets (preliminary expressed & profit & loss account debt balance)
II. Turn over ratios or activity ratios:
These ratios measure how efficiency the enterprise employees the resources of assets at its command. They
indicate the performance of the business. The performance if an enterprise is judged with its save. It means ratios
are also laced efficiency ratios.
These ratios are used to know the turn over position of various things in the ___________. The turnover ratios are
measured to help the management in taking the decisions regarding the levels maintained in the assets, and raw
materials and in the funds. These ratio s are measured in ratio method.
cost of goods sold

1. Stock turnover ratio =
average stock
Here,
opening stock  closing stock
Average stock=
2
Note: Higher the ratio, the better it is
sales
2. Working capital turnover ratio =
working capital
Note: Higher the ratio the better it is working capital = current assets – essential liabilities.
sales
3. Fixed assets turnover ratio =
fixed assets
Note: Higher the ratio the better it is.
sales
3 (i) Total assets turnover ratio is :
total assets
Sales
4. Capital turnover ratio=
Capital employed
credits sales or sales

5. Debtors turnover ratio=
average debtors
5(i)= Debtors collection period= 365 (or) 12
Turnove ratio
Here,
opening debitors  closing bebtors
Average debtors =
2
Debtors = debtors + bills receivable
credit purchasers or purchases

6. Creditors turnover ratio =
average credetors
365 (or) 12
6 (i) creditors collection period=
Creditor turnover ratio
Here,
opening  closing credetors
Average creditor=
2
Creditors = creditors + bills payable.
Note: lower the ratio the better it is.
3. Financial ratios or liquidity ratios:
Liquidity refers to ability of organisation to meet its current obligation. These ratios are used to measure the
financial status of an organisation. These ratios help to the management to make the decisions about the
maintained level of current assets & current libraries of the business. The main purpose to calculate these ratios is
to know the short terms solvency of the concern. These ratios are useful to various parties having interest in the
enterprise over a short period – such parties include banks. Lenders, suppliers, employees and other.
The liquidity ratios assess the capacity of the company to repay its short term liabilities. These ratios are
calculated in ratio method.
current assets
Current ratio =
current liabilitie s
Note: The ideal ratio is 2:1
i. e., current assets should be twice. The current liabilities.
quick assets
Quick ratio or liquid ratio or acid test ratio:
Quick assets = cash in hand + cash at bank + short term investments + debtors + bills receivables short term
investments are also known as marketable securities.
Here the ideal ratio is 1:1 is, quick assets should be equal to the current liabilities.
absolute liquid assets

Absolute liquid ratio=
Here,
Absolute liquid assets=cash in hand + cash at bank + short term investments + marketable securities.
Here, the ideal ratio is 0,0:1 or 1:2 it, absolute liquid assets must be half of current liabilities.
Leverage ratio of solvency ratios: Solvency refers to the ability of a business to honour long item obligations like
interest and installments associated with long term debts. Solvency ratios indicate long term stability of an
enterprise. These ratios are used to understand the yield rate if the organisation.
Lenders like financial institutions, debenture, holders, banks are interested in ascertaining solvency of the
enterprise. The important solvency ratios are:
outsiders funds Debt

1. Debt – equity ratio= =
share holders funds Equity
Here,
Outsiders funds = Debentures, public deposits, securities, long term bank loans + other long term liabilities.
Share holders funds = equity share capital + preference share capital + reserves & surpluses + undistributed
projects.
The ideal ratio is 2:1
share holder funds

2. Preprimary ratio or equity ratio=
total assets
The ideal ratio is 1:3 or 0.33:1
3. Capital – greasing ratio:
(equity share capital  reserves & surplusses  undistributed projects)

=
Here,
(Outsiders funds  preference share capital )
higher gearing ratio is not good for a new company or the company in which future earnings are uncertain.
outsiders funds
11. Debt to total fund ratio=
capital employed
Capital employed= outsiders funds + share holders funds = debt + equity.
The ideal ratio is 0.6.7 :1 or 2:3

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MANAGERIAL ECONOMICS AND

III B.Tech I Semester (JNTUH-R13)

INTRODUCTION TO MANAGERIAL ECONOMICS

Meaning & Definition:

Nature of Managerial Economics

The other features of managerial economics are explained as below:

Scope of Managerial Economics:

a. The selection of product or service to be produced.

a. Operational or Internal issues

2. Pricing and competitive strategy:

3. Production and cost analysis:

6. Capital or investment analyses:

1. The choice of investment project

B. Environmental or External Issues:

a. The type of economic system in the country.

Managerial economics relationship with other disciplines:

1. Relationship with economics:

2. Management theory and accounting:

3. Managerial Economics and mathematics:

4. Managerial Economics and Statistics:

5. Managerial Economics and Operations Research:

6. Managerial Economics and the theory of Decision- making:

7. Managerial Economics and Computer Science:

A successful managerial economist must be a mathematician, a statistician and an economist. He must be

THE ROLE OF MANAGERIAL ECONOMIST

1. What is managerial economics? Explain its focus are as

1. Managerial Economics as a subject gained popularity first in______. ( )

2. When the subject Managerial Economics gained popularity? ( )

4. Which subject bridges gap between Economic Theory and Management

5. Application of Economics for managerial decision-making is called____. ( )

6. Which areas covered by the subject “Managerial Economics”. ( )

7. The relationship between Managerial Economics and Economic Theory is

9. Managerial Economics is close to_________Economics ( )

10. The theory of firm also called as_____________. ( )

11. “Any activity aimed at earning or spending money is called ____activity”. ( )

Note: Answer is “C” for all the above questions.

Introduction & Meaning:

Price of Appel (In. Rs.) Quantity Demanded

When the price falls from Rs. 10 to 8

Law is demand is based on certain assumptions:

1. This is no change in consumers taste and preferences.

Exceptional demand curve:

2. Veblen or Demonstration effect:

Factors Affecting Demand:

1. Price of the Commodity:

2. Income of the Consumer:

3. Prices of related goods:

4. Tastes of the Consumers:

8. Expectations regarding the future:

9. Climate and weather:

10. State of business:

Types of Elasticity of Demand:

There are three types of elasticity of demand:

1. Price elasticity of demand

1. Price elasticity of demand:

Proportionate change in the quantity demand of commodity

A. Perfectly elastic demand:

B. Perfectly Inelastic Demand

C. Relatively elastic demand:

D. Relatively in-elastic demand.

E. Unit elasticity of demand:

2. Income elasticity of demand: